Tag: VP Long Term Portfolio

Management Q&A

SHILPA MEDICARE 2015 AGM

Shilpa is an API provider of oncology molecules and other niche molecules. Much of the API provider’s revenues depends on the fortunes of the formulator whom he supplies. For eg: formulator may have FDA issues, plant upgradation, may decide to get out of some formulations etc which in turn affect the demand of Shilpa’s APIs. To overcome this, Shilpa has decided to get into formulations of some of the molecules which may give it better control over the molecules to target.

Shilpa does not work with innovator/originator currently. Predictability is little less in generic business. Hence, Shilpa refrains from giving numbers.

This year there was more talk of First to Files (FTF) for formulations. Shilpa will be filing its first FTF this year (own name, however, it has filed FTFs for its partners). Shilpa management feels it has the strength in molecules to file FTFs in its own name.

Shilpa has taken significant capex and investments last few years and the revenues will come from 2017-18. Shilpa has around 400 R&D engineers (300 at Vizag and 100 at Raichur) and has filed around 175 patents of which 75 have been filed last year. However, it can be that one molecule itself can have up to 5 – 10 patents.

RAICHEM MEDICARE LIMITED (JV with ICE and PCA, Italy)

PCA is a subsidiary of ICE Italy (was acquired by ICE). ICE manufactures cholic acid while PCA manufactures deoxycholic acid and its derivatives like ursodiol etc. Cholic acid is used for manufacturing deoxycholic acid. PCA also manufactures the API and is not into formulations. ICE and PCA over a period of 50 – 60 years have worked on only this molecules and have an edge over any other company (ICE controls 70% of the world’s cholic acid demand while PCA controls 45% of the world’s demand for deoxycholic acid) which primarily is in R&D and sourcing as it is naturally produced (ox bile, chick bile etc). ICE and PCA can increase prices of this molecule as and when required. Shilpa just provides the CRAMS for manufacturing of ursodeoxycholic acid where raw material, process, technology etc are provided by ICE only.

The current market for this API is 1500-2000 tonne which is around Rs.2500 crore in value terms. Currently, Shilpa has 8-10% of the API market share while the JV will have 2 – 2.50 times the existing capacity of Shilpa for manufacturing the product. There is a lot of shortage of this molecule worldwide. Shilpa has orders up to two years from ICE. However, due to supply constraints it is not able to fulfill the demand. ICE does not want to expand in Europe due to high costs and other issues. Scaling up will be easy for the company here and through JV their interest and longevity will be higher. ICE has 50% stake in the JV. It will be ICE’s only facility outside Italy. The reason for ICE to stick with Shilpa is trust. The benefit for Shilpa in the JV is it is de risk its major revenue source and freeing up capacity at its API plant for other business divisions. Shilpa also has contract for selling this API in few markets like India. Once this JV plant is functional, this will be a separate profit center for Shilpa (kind of self pilot mode).

The plant is a world class one and took almost two years for construction. The plant is in final stages of construction and will be ready in one – two month’s time. The company has already started working on exhibit batches and by June, 2016 the company will have 9 – 10 months of stability data after which it will file for DMF in Japan. This will start yielding revenues in FY17 but majority of it will come in FY18 after all the shifting has been done from the standalone API facility. It might happen that due to shortage of this molecule, Shilpa on standalone basis might continue to supply for few years too.

ANTIRETROVIRAL (ARV)

Earlier, the vacated facility for manufacturing of ursodeoxycholic acid was proposed to be used for manufacturing of ARVs. However, due to less clarity on the issue of when the manufacturing of ursodeoxycholic acid will stop in standalone operations, the plan has been put on hold. If Shilpa starts constructing a new block for ARV and all the transfer happens to Raichem JV soon, it will lead to idle capacities. The company will take a decision on this in short term (three to six months). Apart from the four molecules (QUAD), the company has also worked on few other molecules at R&D stage. Company has plans to go into formulation also in the long term for ARVs.

JAPANESE CRAMS

Shilpa Medicare has ventured into CRAMS with a Japanese pharmaceutical company to produce tranexamic acid. The company is dedicating an entire block for this arrangement, the construction for which is expected to be completed by December 2015. The total cost incurred on the capex was Rs.31 crore. The manufacturing of the exhibit batches will start from January, 2016 onwards. The capacity for this block will be 100 tonnes and can result in revenue of Rs.50 crore. However, it will have higher margins compared to the current arrangement with ICE as Shilpa will procure raw material directly and will have its own manufacturing process. Shilpa has also got license to sell it in few markets (not regulated markets like US or EU). Like ICE, the partner has expertise in the manufacturing of this molecule and has extensive experience in it.

Shilpa’s management views this a stepping stone with relationship with Japanese Generic players. Shilpa is the only company whose API is registered in the Japanese markets. Establishing relationship generally takes a long time and they initially start with only small volumes and scaling up happens over a longer period. A few large oncology companies have also visited Shilpa’s facility. A lot of patience is required for working with Japanese partners and there is no room for short cuts. This can be a sustainable model after 5-10 years and a separate revenue stream.

Unlike US, the Indian pharmaceutical companies except for Lupin haven’t been able to make a mark in the Japanese markets. Reva Pharma, a sister concern, is an official advisor for Indian Government for Japanese pharmaceutical companies. It has been instrumental in asking PMDA, the pharmaceutical regulatory authority of Japan to set up an office in India. Japanese market has very low generic presence which is expected to increase significantly going forward benefitting Indian pharmaceutical companies.

REGULATORY APPROVALS

API Facility: The USFDA inspected the plant in March, 2015 and there have been few observations. However, none of them are related to data integrity, which has been a major concern for the pharmaceutical companies. The company has replied to these observations. The company has been regularly writing mails and following up with the authorities and expects an outcome by October/November.

Formulation Facility: Shilpa’s Jadcherla formulation facility was inspected by USFDA recently. The management was expecting the inspection after January, 2016 but an ANDA getting into bio-equivalence/ later stage of approval triggered the inspection. The inspection happened over 10 days and there were few 483 observations. However, there are no data integrity issues. Shilpa has responded to these observations and is expecting FDA approvals for this plant by around mid 2016 after which it is expecting to get ANDA approvals one by one. Shilpa Medicare has shared these observations with its customers and they are confident of getting the FDA approval soon. Many of the issues related to regulation are because of lower level employees taking short cuts. Shilpa has taken many steps to address this including hiring an ex-FDA inspector (who charges USD 280,000 annually) consultant to visit the plant and give inputs and training.

Shilpa has got approval from Brazilian, Mexican and EU authorities (that Slovenian approval was for whole of EU). Argentinean regulatory approval has also been triggered and they might come for inspection.

As per the management, USFDA is trying to categorize pharmaceutical companies into various grades and the grades will decide the frequency of USFDA audit going forward.

APIs

The company has 20 DMF filings in the US markets. The same molecules have been filed in the EU market as well. The company has a hybrid approach for development of new molecules – sometimes R&D employees find a molecule lucrative, sometimes customers approaches and few of the times the management finds a molecule to work on. Shilpa is even working on few molecules which have expiry in 2025 – 2027 or are currently undergoing clinical trials. The key here is non-infringing patent and being able to tie up with formulator. The company has worked on 35 molecules out of which 17 have been commercialized till date. In APIs, Shilpa has a lot of strength in few of the molecules where it can impact the prices of it. However, the company does not have a philosophy of gaining market share by reducing the prices. Competitive intensity of a particular molecule decides the step taken to manufacture it. If it’s a competitive molecule, R&D people start from the scratch and work from N – 5 and N – 4 stage to reduce cost while in not so competitive molecule the company goes back to just N – 2 stage as well. China is expected to be the biggest oncology market in the medium term. In US, out of every 10 new molecules being approved by USFDA, seven are in oncology. Few molecules which were discussed:

Capacetabine: Shilpa has expertise in this molecule and has begun expanding the capacity four fold. Post the expansion, Shilpa will have around 25% of the world’s capacity. Although, the prices have come down, Shilpa will still be able make decent profits and benefit from increase in volumes.

Gemcetabinie: Intas had completed expansion at its plant last year. So they took less quantities from Shilpa in FY15. As many finished players have entered the European market, production has fallen by a third. Capecetabine is expected to make up for this.

Bortezomib: Shilpa is expected supplying to many formulators as it has a patent for the molecules under which it works (stability) even in some specific temperatures.

Imatinib Mesylate: This will be the next big molecule for the company after Capecitabine. Company has an edge in this molecule.

Ambroxol: Shilpa also wants to diversify into non-oncology molecules. They have expanded capacities in this molecule four fold. The capex for the expansion was around Rs.30 crore. Although, the molecule has lot of competition and is not difficult to manufacture, they have lot of experience in it, more filings and better quality. The market for this molecule is expanding. Other companies are decreasing the price while they are increasing it.

On being asked about the molecules which they are currently working on (taken from Karvy report and company’s website) have a market size of more than USD 5 billion, the management said that they are also working on bigger molecules than the ones mentioned. Post approval from USFDA, Shilpa might take further increase in capacities for the US market. The company works at various levels to ensure that its process and molecules are non-infringing. Shilpa had won a case against Bristol Myers Squibb (BMS won against Dr. Reddy’s, Natco and Hetero) in India for a molecule despite the company assuring BMS that they don’t have plans to launch it in the domestic market. Pfizer had also launched a case against Shilpa for a molecule in India. However, after Shilpa told them that they won’t be launching that molecule in the Indian markets, they withdrew it.

FORMULATIONS

USA

Shilpa has filed 13 ANDAs as on date. Out of these 13, 5 have been filed in Shilpa’s name while 8 have been filed by the partner. The marketing arrangement for this filing is:

Own filing: Shilpa will incur the R&D costs and tie up with the partners at various stages of development of the molecule. If Shilpa ties up with partner at the beginning of development of molecule, they will have lower profit share while if they tie up after the filing of ANDA, it will have higher profit share. Out of the 5 filings in its own name, it has mix of all. Shilpa has a marketing arrangement with the partners where they sell our products in the US market. Shilpa will be filing our first FTF this year in our name. Typical cost of filing an ANDA is Rs.5 – 6 crore plus litigation costs. Going forward, Shilpa will try to file new molecules in our name. Shilpa had filed its first ANDA in its own name in Dec 2013.

Filing in partner’s name: Here the strategy is to work on CRAMS basis (cost plus profit). R&D expenses, litigation cost etc are incurred by the partners. The main purpose of this model is to hedge its API supplies also. For off patented molecules, Shilpa ties up with 3 – 4 formulators while for FTFs, they exclusively tie up with just one formulator (the company has filed for few FTFs through its partners). The partners chosen are good in marketing and have capability of garnering good market share.

The company currently has one line for manufacturing tablets and one for injectable at it formulations plant. The company has fully tied up for its existing lines for manufacturing of tablets and injectables. The company is constructing one more line for tablets and one for injectable at its formulations plant, the cost for which is expected to be Rs.30 – 40 crore. The construction for the new lines is expected to be completed by December – January. In oncology, there has been gradual shift towards tablets from injectables (unlike other segments). The company is also planning to build third dry powder injectable line at its existing facility. It will be first such dry power line for oncology products in India. The total capex for the line is expected to be Rs.200 crore. The company might go for another expansion in three to four years which along with the dry powder line will cost around Rs.450 crore. For third or future lines, the company might tie up for innovators also. The company might go for equity dilution for the capex in near to medium term.

For formulation facility, the company has tied up with new customers. In FY16, the company has plans to file five ANDAs (one in its own name and four in the partner’s). The company is not looking to file for biosimilars currently due to high cost involved (USD 15 million per molecule) as well as lack of clarity from the regulatory authorities. However, there seems to be some clarity emerging from the regulators and the company might plan to go for its manufacturing in the long term.

EU AND OTHER ROW MARKETS

Company has filed or planning to file five dossiers for the five ANDAs it has filed in the US in its own name in European market too. The approval from the EU regulators usually takes less time of around one year as compared to more than two three years for the US markets. The company’s partners are filing for formulation drugs in Mexican and Brazilian markets.

Going ahead formulations will be major revenue generator for Shilpa. The Jadcherla plant is being setup with advanced machinery which will have lesser chances of recalls. Shilpa had made investments of around Rs.250 crore in this facility. Shilpa Medicare has got a strong IPM department which will help decide which molecules to pursue.

FUNDING GROWTH/EQUITY DILUTION PHILOSOPHY

Shilpa does not like to take too much debt. If a company has too much debt, the focus is on repaying debt instead of thinking of new ideas. Besides, having cash in the bank helps Shilpa to fund its new R&D proposals. Hence, all the capex will be funded with mixture of debt, equity and internal accruals. Equity dilutions might be done at good valuations (most probably for future capex) which can lead to less dilution. The company has a philosophy of funding big capex with a mix of internal accruals, debt and raising more equity.

TALENT RETENTION/IP RISKS

As per the management, Shilpa does not have problem of retaining top talent. Shilpa’s R&D head has been with the company for more than 20 years. There is a bit of attrition of lower levels like chemists. However, top level R&D scientists continue to stick with Shilpa. Most employees get between 15-30% hikes every year. They are given a free hand in R&D projects with management supporting innovative proposals. One of the reasons is that Shilpa management likes to keep cash in bank instead of borrowing too much. It can fund these small R&D proposals easily and not wait for funding. Shilpa is thinking of ESOP incentives for retaining top talent. Salary is in line with the best in the industry. Sometimes people leave at 3x salary. However, this has no impact on Shilpa. They file a patent at initial stages for the idea on feasibility analysis. This prevents the new company from filing patents for these ideas once the chemists leave.

JOINT VENTURES/SUBSIDIARIES/INVESTMENT PHILOSOPHY

Shilpa is keen to fund smaller companies (startups) with good people and good technology. This requires management with VC kind of mindset. This keeps the company abreast with new technologies and new ideas like nano technology etc and new drug delivery systems (NDDS). NDDS will help Shilpa in future projects through launch of its own formulation through them.

MAIA Pharma: Shilpa funded initial round and recently there was another round of dilution in which Shilpa did not participate at around four times the valuation at which Shilpa had invested earlier. They are filing a 505(b) (2) and Shilpa will be providing API too.

INM Technologies: It is working on nano technology. The company is based out of Bangalore. The company also bought an R&D center at Bangalore for this technology.

Shilpa has funded Rs.8-10 crore last year in these ventures and is looking to fund the same amount in next 2-3 years. The company has philosophy of funding new ideas with good technology and not spend too much money on a single idea.

Loba continues to be in red and seems to be a mistake committed by the management. There are lot of regulations in the market and management is trying to make it self sustainable.

OTHER POINTS

All revenues are in USD and thus not exposed to Euro depreciation

Admired Alembic and Torrent apart from Natco

No targeted R&D/sales ratio. Everything is based on requirements

Most of current Oncology molecules are Injectables. But after 5-6 years most expiring molecules are Orals.

The company won an award for Patent work recently and shared the stage with big pharmaceutical companies like Divi’s and Aurobindo.

Disclosure(s)

Ankit Gupta: More than 5% of Portfolio in the Company; Holding for more than 1 year; No transactions in last 30 daysAnanth Shenoy: More than 5% of Portfolio in the Company; Holding for more than 1 year; No transactions in last 30 daysAyush Mittal: More than 5% of Portfolio in the Company; Holding for more than 2 years; No transactions in last 30 days: ; ;

Management Q&A

Kitex Garments Management Q&A : Aug, 2014

1. INDUSTRY/INDUSTRY STRUCTURE

We just finished a tour of the Garmenting and the Knitting-Bleaching-Fabric-Processing factories. Its nothing like we have seen before. You have set up a high-quality infrastructure on par with the best in the world with state-of-the-art advanced machinery. Who were the early influencers? How did you benchmark Kitex to be where it is shaping up to be today – a preferred choice of the largest global retailers? [Kitex Production- Infrastructure Video]

Well I guess the credit for it goes to my dad and the early training he put me through. He was a strict disciplinarian and he ensured I learnt to respect every aspect of the work ongoing in our factory. As a 13 year old, I was started out from cleaning the lavatories, to the shop-floor, to becoming a machinist, technician, bleaching and processing to garmenting operator.

I grew up with the ethos and the confidence of trying to do something different from the run-of-the-mill. We were not afraid to take risks. We were always prepared to order and try out the latest advances in machinery that wasn’t being used in the country. Somehow from the initial days we focused on infant wear. Certainly I have traveled and seen many factories worldwide. But we haven’t copied blindly. We have adopted creative solutions that we found could add to quality, efficiency or productivity.

We make it a point to publish results immediately after the year-end – even that is a creative first!

The working & living conditions for the workers that we witnessed was the most striking – certainly a few notches above comparable factories in India/Asia. What would you attribute that to?

My early training ensured the need to provide good working and living conditions for our workers was internalised early on. As we grew, we therefore had no hesitation in investing in people, infrastructure and processes that complied with all social and environmental norms right from the start.

Kitex has established itself as a large manufacturer of infant wear globally and made rapid progress in the last few years. Kindly share with us more on the global market size, growth areas for next few years, and Kitex’s own unique positioning and current market share.

Kitex specializes in infant wear (0-24 months) market. Trust and Quality play a big role in consumer buying choice. Quality Standards on fabric and dye stuffs, colours and printing methods are much stricter to ensure products are infant-friendly and harmless. Chemical dyes cannot be used in the fabric (child saliva often comes in contact with fabric), for example. Parents lay great emphasis on Trusted Brands like Carter, Babies-R-Us, Gerber, The Children’s Place, Mothercare and a few others – brands that have endured over several decades.

Infant wear has continued to enjoy a relatively protected niche. Unlike most textiles/garment segments, infant wear market is not commoditised. It is also the only textiles/garments segment to have proven to be relatively recession-proof.

These large brands sell in huge volumes in US, Europe and rest of the world. Globally there are 12 companies of some scale that manufacture volumes large enough to meet the needs of these large brands. Winlu (China) is the No. 1 player with 7.5L pieces per day today. Gyn (Singapore) with 6.5L pieces per day is the second largest. They have manufacturing facilities spread across various countries. At 5.5 L pieces per day, Kitex has now emerged as the 3rd largest manufacturer.

(US $20 Bn market, Canada, Japan & China – $25 Bn, as per Carter AR). Kindly give us a sense of how big is the runway.

US is a huge market yes, but volumes in US market are stagnant.

But Asia is growing very fast. India, China and Middle East growing very fast. Korea there are lots of stores. China there are lots of stores opening. Most International brands are today present in India – the aspirations of the new generation are different. In the next 2-3 years I see every brand will be here in India – and not just the big cities.

Infant market is growing rapidly in India. Earlier a family had 5-6 children. Now its 1 or 2 children at most. [reels of many employee names with single child, speaking to AGM Finance]. Parents are ready to spend more. There are so many shops today targeting infants & toddlers. Even a small place like Cochin has 7-8 toy shops. There are small cars prices at 25000, 30000, 40000 and people are buying. I went back to one shop f3 days later for a Jeep for my son – the piece was gone – it was for Rs 32000! Nothing comes cheap in these shops. Small cute chappals for the kids cost Rs 700-800. Parents are willing to splurge.

Some brands like Carter may be selling upwards of $500 Million in India 3-5 years down the line and there will be fast ramp-ups. Look at US Population – 300 Million; India’s 4x that and couple that with twice the birth-rate; that’s 8x the US market potential in India only.

Infant wear for 0-2 years has an added advantage. 2-month and 3-month old toddlers grow very fast till 2 years, adding 40 gm or so every day or about 1.2 kg every month.

But the price-structure may be very different?

Actually it is worth noticing that the US market sells products at half the price of the Indian market. A Tommy Hilfiger shirt sells for Rs 3500 in India. In the US it comes for $35-40. Buying at a sale you can get it for $25, so at a discount you can get it for Rs 1500. I am a fan of Tommy Hilfiger, I buy all my shirts in the US!

In US the Sale structure is very interesting. The Initial Sales are placed at a Value that gives them 80% margin. They make all the profits there. Then they start selling at 60% margin, and next at 40% margin and then finally at 20% margin to liquidate stocks and be ready for the next spring/fall season.

When the market really opens up in India in next 3-5 years, it will be good for players like us. We will be able to save something like 20% straight on the duties and logistics costs. Gerber sells a body suit for $2 in the US market or Rs 120. It sells 1 million pieces a month at Walmart at $1.78. A comparable kids garment in India sells for Rs 350-400.

But what about product quality? Jockey International and Jockey India products are very different and at different price-points.

Yes you are right if you take the example of Jockey International products and those that are offered in India. There is a reason for that – Jockey products are offered by a company in India under a License from Jockey. As a Licensee you have the freedom to design and manufacture as per Indian market conditions. However Franchisee operations are different – where the same global quality & standards & products are offered.

Mothercare hasn’t taken the licensing route and has established many stores in India under company owned and Franchisee operations. We expect similar initiatives from the others when they establish their presence in India.

Is it right to say that the Industry structure is favourable for large manufacturers like KItex – Large Retailers have to come to Large Manufacturers?

Look there are only 3 or 4 major players from India. All others are at $1Mn (or sub) kind of volumes. Gerber has only 3-4 vendors. Carter has 2 approved vendors and is trying for 1 more.

Who are these large vendors?

Best Corporation, Jay Jay Mills and First-step are some of the larger established vendors.

But we have heard Mothercare sources from 15 and more vendors for infant w
ear?

Mothercare came to India much earlier and has established more vendor sources.

As companies scale up direct sourcing, are large scale global sourcing firms like Hong Kong based Li & Fung getting limited. Carter scaled up direct sourcing from 5% to 30% in 2013 and has aims of taking it up to 50% in next 2-3 years? Earlier the same sourcing agent was handling 70% of inventory purchases. How widespread is this trend? What does it mean for a manufacturer like KItex – in working capital management & margins?

Not true. Direct Sourcing is being pursued aggressively by players but with little results to show. Just where are the manufacturers with scale? And sourcing from a large number of vendors directly, is proving complex.

Three years back a leading player’s annual direct sourcing target was $80 Mn but they could get only $22 Mn. Last year they planned for $500 Mn direct sourcing in 3 years but are making slow progress. The same player wanted Kitex to supply $150 Mn in 3 years. We are not ready to supply more than $50 Mn to a single player. It is much safer to spread the same volume between 3-4 leading players.

Once you have a trusted supplier relationship going with a global retailer, kindly give us an idea of the level of penetration possible? $150 Mn is just 5% of Carter’s annual sales today.

We have very good relationship with all our Customers. Over the years of association, in many cases it becomes like personal family relationship. Some of them call me at any time of the night, on business. Some of them I have to call every weekend, wherever I am.

We enjoy preferred supplier status today. We can keep growing the relationship with all of them steadily. As mentioned before, though we have offers to scale up very significantly on one or the other relationship, we prefer to go about it in a balanced way – not expose ourselves to undue risks/pressures.

Does any scale-relationship with any one retailer, restrict or impose any limitation on sourcing by other Brands or direct competitors?

Not at all. US way of business is different – they are very fair. Just like they want us to be fair in all our practices as well like not forcing our Labour force and meet all social compliance norms – hygiene, work timings, fair wages, working conditions, etc.

They don’t/won’t interfere in our business at all, there is complete freedom. Gerber or say The Children’s Place don’t ask us about the level of business that we do with others.

2. GLOBAL CUSTOMERS

Can you explain the difference between European brands like Mothercare and US brands like Carter?

Mothercare is UK based and sells at a premium. Their styling is simpler – more white-based. More family oriented. ” I love you Mummy” or “My Daddy” – with prints or embroidery.

US is more design oriented with lots of colours and various styling. Gerber and Carter sell in huge volumes in the US market. As mentioned before US market is the cheapest in the world. Quality and standards are enforced. Customers don’t like a product they can return it. They have some health problems – they can make a claim.

It is interesting to note that KItex made its entry with Gerber Childrenswear (mass-market player) 14 years back and only in last few years getting into sourcing agreements with Carter premium segment player). Kindly comment.

As mentioned before we do not have a preference for any of the bigger players. We would like to be in a steady relationship with all of them and continue to grow the business. There is enough scope with all the leading players.

But some of them like Carter are more profitable and growing, whereas someone like Gerber has changed hands 4-5 times, and Babies R Us is a subsidiary of the loss-making Toys R US? So isn’t it fair to assume there would be a preference for the growing more profitable customer?

Actually, Gerber is the most profitable customer for us. They source in huge volumes and some of their designs run unchanged for 6 months or a year sometimes. The efficiencies and productivity we derive from there is much higher.

Apart from Carter and probably Babies R Us, most of the global retailers are finding it tough to compete and have been having financial difficulties and/or downsizing home operations to concentrate on International operations like Mothercare? Kindly comment and educate us on on the risks from this front?

in Europe, population is coming down, birth rate is coming down. Most families have maximum 1 child. Its like a cycle you know. The US has also gone through that stage of 1 child. Now everyone there wants 2-3 children. They are coming back. My feeling is Europe will also come back a few years down the line.

But Middle East is selling very well. In 2 years India and China will be selling very well. Take Mothercare, earlier they used to sell 80% in UK and 20% Internationally. This is now getting reversed.

But in this process of major market shifts, profitability is at risk? As per Mothercare AR their top priority is to replace profitability, and per casual enquiries by us their sourcing people have very stringent profitability targets?

Yes, they are aggressive on pricing. They compromise maybe a bit on design and styling. It is certainly not affecting the manufacturers like us.

Most Brands are however concentrating more on E-Commerce? Their e-commerce sales are doubling every year? What does that trend mean for manufacturers like you?

Yes E-commerce is shaping up very strongly. In US, in next five years e-commerce may occupy more than 80% market share. No one has time to travel. Standards are very tight and customers are assured that they will not be cheated. Customers have right to return the purchase if they are not satisfied in any way.

But E-Commerce has also meant margins are thinner? Brands like The Children’s Place have increased sourcing from places like Bangladesh drastically, to meet profitability? Kindly comment.

In Bangladesh wages are 2000-3000 per month compared to 8000-10000 in India. Kitex wages are among the highest in textile sector in India. Bangladesh superiority comes where products involve lots of manual labour and less machinery. But in infant wear, machine productivity and process is equally important and Kitex can compete with Bangladesh lower labour cost with its higher efficiency and productivity.

Kindly give us a sense of the Revenue mix from your top customers. What level of penetration have you been able to achieve over the years?

First 2 years they watch our performance and execution – quality and on-time delivery, etc. Just like we watch them and the relationship. Beyond that stage, all our buyers are in the $13-15 Mn range or $28-30 Mn range.

To give you an example, a new relationship is at $14-15 Mn for us currently – this can double – they are also watching. They are currently sourcing 60% from India and 40% from China. They are looking to increase this to 80-85% from India, 15% to China in next season. They don’t mind paying 2% higher here – value is much more.

In the past you have tried to risk-diversify across smaller retailers in US & Europe. Apparently that did not work out and you have reverted back to focusing on the large customers. Kindly educate us on the reasons for the same?

Yes, we did experiment with that. In our own calculations we had reason to believe that would be more profitable. But it didn’t turn out like that. Volumes were smaller, designs changed faster, our utilisation, efficiency and hence productivity was much lower. Order flow was sometimes volatile, scaling up was proving difficult. We had to move away from that model.

Kindly educate us on the Jockey Relationship and its potential for next few years?

We forayed outside of infant-wear market on specific request from an existing Customer. Gerber had taken the children’s inner-wear license from Jockey and wanted to manufacture it out of China. They got it developed there but Jockey rejected on quality front. Subsequently they jointly came to us for a new concept OUTLAST® technology for inner wear, which regulates skin temperature and helps you feel cooler in everyday situations. We are the only manufacturer for that product. We make 2x the Sales for the same production time as infant wear as value-addition is much higher because of special chemicals and raw materials. Sales have been flat for last 3 years, as this is a niche segment. The project was taken up to showcase our ability to make such a product with complex technical requirements. It is more of an aberration. Even Arvind Ltd. had tried but failed to deliver on this product.

So it will not be incorrect to say you will continue to focus on infant wear 0-2 years segment only? You do not even need to get into the Toddlers segment 2-4 years. You see enough opportunities for you to harness and scale up in infant wear itself for the next few years?

That is right.

3. TECHNOLOGY/QUALITY/DIFFERENTIATORS

Kitex today has established a world-class state-of the-art manufacturing plant with the latest advanced technologies. It has shown the vision and the self-confidence to do things differently than most others in the sector. Reportedly it has been a lead-user of latest advances in technology/automation. Kindly take us through this evolution. How were the early days? How long did it really take to start getting noticed?

From 1995-2000 we struggled. Buyers took us for a ride and exploited us. Gradually we understood the game and started investing in the Safety-Security- Social and Environmental compliance norms. We took big risks and invested in the latest advanced machinery. To maintain quality we standardised on our yarn suppliers – both in North and South India – and nurtured them. Today we have 4-5 major suppliers. We have agreements with them for guaranteed off-takes. Today we are known for the best quality at competitive prices.

What have been the critical milestones in differentiating Kitex as a serious player – able to rise upto and match/exceed the stringent demands of global customers?

2. The right raw materials – Kitex specified high-quality yarn – based on Okeo Tex Class I – normally not available in the market 3. Superior process chemistry used for bleaching and fabric processing 4. Use of Organic Dyes 5. Lastly our Labour strength – which we can proudly say is much better, more efficient than elsewhere – they are better trained, disciplined and punctual. Our labour utilisation/efficiency levels are close to 50-60% whereas most would struggle at 40-45% in the industry. We pay them the highest.

So, how did you set out to do things differently?

Well it depends on individual capacity I guess. It is in the Execution. It is in the Creative Ideas. You have to design new things – you have to think!

Kindly explain to us the manufacturing process value-chain and how Kitex has been able to add value and where – Yarn—->Fabric—->Dying/Bleaching—–>Knitting—–>Cutting—->Sewing.

Yarn: Kitex specified superior quality yarn based on Okeo Tex Class I vs normal yarn used by other vendors

Knitting: Advanced machinery from Italy.

Bleaching/Processing: Technically superior Open Width Continuous Bleaching process vs Soft Flow process used by others; completely controlled by advanced Robotics machine – installed recently, again a first-in-the country. Only one person required to operate the 70m long bleaching line

Dyeing/Finish: Only organic dyes are used; Recently we have used Avocado based dyes with excellent results; started recommending these to Buyers

Sewing: Advanced high-speed more efficient Japanese machines with lower power consumption

You continue to mention Quality as your biggest differentiator. Yet, isn’t it true that the Buyers specify the product they want? They specify the base fabric, the colours and the dyes, even the printing method, etc. They inspect and test as per specifications before dispatches are allowed. So where is the quality differentiator, really?

While dye stuffs, processing and finishing play their part, the difference comes mainly from the Yarn specifications. The feel of the fabric changes drastically depending on the yarn used. As mentioned before we only use Kitex specified superior grade yarn based on Okeo Tex Class I yarn. We have contracted suppliers with guaranteed off-takes of 100T/200T a month from them – on strict yarn specifications provided by us.

You will see that we are the only vendor in the country that specifies upfront the yarn that goes into our fabric. Interestingly the buyers do not specify what type of yarn is to be used. When they specify base fabric – they will mention either Interlock fabric, Single Jersey or Rib Fabric and along with that 150 gsm or 180 gsm which is a only a measure of the density. They do not insist on a specific yarn quality. The usual standard is 18% Combing on 100 Kg whereas 15% combing or 10% combing, even 1% combing are possible for different levels of value addition.

The fabric feel ultimately depends on the quality of the yarn used. What kind of cotton is used in the yarn – longer 8 mm staple or shorter 6mm or less staple. The longer staple gives more strength. In normal Okeo Tex Class I atleast 20% long staple cotton is to be used. There is a variety in Gujarat which is the most suited. We specify all that in our yarn specifications to our suppliers. Because of that we can ensure CPSI of 2700 (a measure of yarn strength/breakage) versus 2000 for normal yearn. Defects are nil or of the order of 1/3rd to 1/4th that from normal yarn. There are some 10-15 different parameters where Kitex specified yarn is significantly better quality than normal yarn – this is what we try to showcase and explain to our buyers.

Well usually there is a reason for such omissions by both vendors & buyers. It must be taking up your costs. So how do you compete, then?

Certainly, it is a competitive world, and we have to be competitive. What we offer by way of higher input cost raw materials and investments in superior technology machines and processes, we make up in volumes and constantly improving on efficiency and productivity levels. Today we are at 60% utilisation levels and we will take it up to 70% with more recent investments in advanced machinery and robotics. Beyond that it’s not possible in Knitting industry.

Let’s examine the impact of Sourcing by large buyers? Don’t they have stiff sourcing & profitability targets where they are continually focused on shaving of that 2-3% and exploring manufacturing from low-cost regions that can give them some incremental advantage?

“Sourcing” – as we have known/experienced has changed over the years, especially for the Infant Wear segment. Earlier the accent of sourcing teams was only on pricing. Teams would travel to Asia, visit lots of vendors, decide what to buy at what quantities at a pric
e. Earlier the Buyers (Sourcing folks) were mostly blind to issues other than pricing. Now they are getting a better holistic understanding of the larger issues involved – price-competitiveness is important, but so is on-time delivery and quality as they have realised from sourcing in other regions in Asia (especially for infant wear).

The 0-24 months segment is the most brand-quality-conscious. Colours, quality and design play a big role; there is a lot of Trust in the Product. The Customer’s Product Department decides the Product design, the Planning department distributes according to Sales Plan drawn out. And then the Buyers, Planners, and Sourcing Team gets into action.

Earlier only the Sourcing Team used to come and visit us. Today at major Buyers whole teams drawn from Product Design, Planning, Logistics, Sourcing get involved. Recently when I visited a large Buyer in the US, a 22 person cross-functional team sat down to understand from us and appreciate the myriad of issues involved.

We share with them the impact of using normal yarn vs Kitex specified Okeo Tex Class I yarn. We also share the outlook on Yarn costs, Trims & Accessory costs, Labour costs, and the $-Rupee equation. We provide them advance information if costs seem to be going up – that there may be a 1% cost escalation next year.

Yet, the reality is its a very competitive difficult market. Apart from Carter and maybe Babies R Us, no one is really profitable. They will be trying to find that extra 3-5% savings if they are to scale up a relationship?

Yes, we try to make them understand the impact of compromising on input costs on the quality. They do ask us if we can make cheaper by 3-5%. We say No, we can’t as we will not compromise on quality.

Instead we ask give us a full product line, you will see a 4-5% higher Sales. Retailers and wholesalers have found out that the customer can also easily discern better quality by just the feel of the fabric. The same brand/design (Kitex-sourced) sells out much faster. For example, earlier we had the last row in Babies-R-Us stores, now Kitex-sourced products are placed in first 10 rows. Every season Kitex-sourced garments sold out faster – which led to the upfront placement.

Buyers have started to appreciate that. You see everyone has to survive. No manufacturer can can continuously cut-down on costs. In 2008 in the face of recession, large buyers started squeezing. Every season they would ask for a 2%, 2% reduction. Now no Buyer does that. Why? They know after some time, it is bound to break. They all understand the cost structures today. They tried sourcing from China cheaper. They couldn’t supply. They didn’t get the goods on time, leading to loss of Sales because they had already booked space at places like Walmart and others.

Besides there are lots of sales “tricks” that Retailers resort to. The same product that sells for $2 in Walmart can be sold at $6 somewhere else with some more work (frills & accessories) and better packaging. They know how to sell it. Its like Fashion – not high fashion though. There are buyers who don’t buy at Walmart. There’s a 25% audience segment that does not look at prices. For them most important is the Brand – design & quality.

How critical a role have Technology Consultants/Employees like Christian Strahm (Santex and Strahm Texile Machinery) played in improving quality and matching up to global quality standards required? Have they also played a role in improving assembly line efficiencies and/or de-bottle-necking. Kindly give us a sense of the significance of these contributions.

Well he is a consultant for maintenance and upkeep of processing machinery. He was the owner of Santex Textile machinery company but unfortunately had to sell out. He was employed with us also for some time. Now he has started Strahm Textiles and back to his consultant role with us and visits us regularly.

Kindly educate us on the Jockey Outlast manufacturing line? Are there major process differences? Where? Are the issues the same in scaling up these lines, or are there differences?

Not really. As mentioned before we can make twice the Sales from the same lines as value-addition is higher – raw materials and chemicals used.

4. ORGANISATIONAL READINESS/STRATEGIC

While Kitex has positioned itself strongly today as one of the preferred choices for Global retailers, how ready is it organisationally to harness and execute on the opportunities before it? Kindly share with us the organisation structure and key operating responsibilities and the key people behind them? Their experience base and their journey within Kitex.

We are organised entirely along the lines of our Buyers. Business Managers are assigned to a specific Buyer depending on the volume of the business. For Jockey, we have 1 Business Manager with 500 people reporting to him. For Carter we have 2 Business Managers managing 1000 people under them.

Each Business manager has several functional heads reporting into him. The Production Head, the Sourcing Head, Inventory Head, the Merchandising Head and the Operations Head for Jockey report into the Jockey Business Manager. So each Buyer has dedicated functional heads and dedicated Teams (across Production, Sourcing, Merchandising, Garmenting operations) for delivering on our commitments to that Buyer.

Its not about manufacturing/selling garments/products to the Buyer. It is about selling a factory to a Buyer. We like to sell by Blocks. You buy a Full Block’s capacity and you get a full dedicated group of workers to deliver that for you – the group includes your own sourcing, merchandising, production and operation teams including tailors and sweepers!

That’s why you might have seen that we are organised by Blocks. Each Production Block has its twin but separate Block (in adjacent Tower joined by pathways) for accommodation and dining and other space for the Workers in the Opposite Block.

Wow! That’s a pretty interesting and original way of organising your business around Buyers. But what about the 2nd and 3rd level of Leadership in the organisation?

The 2nd rung of leadership is built around 8 Core Managers – managing operations at the company level – each handling a specific function – Finance, Administration, Production, Sourcing, Inventory Management, Merchandising – and have their own Centralised Sourcing Team, or Centralised Inventory Management Team, for example.

3rd Level of Leadership are the individual Business Managers. And 4th level are the Buyer specific functional heads.

So for each functional head, there is a direct reporting at the Business Manager level and also a lateral reporting at the Core Manager level?

That’s correct.

Also how are the responsibilities divided, what does the Centralised Sourcing Team do and what does a Buyer Sourcing Head decide on?

The Centralised Sourcing Team is responsible for policy setting, vendor identification, selection and nurturing, etc. and managing the individual Sourcing Heads at the company level while the Sourcing Head at the Buyer level can decide which of the 4-5 company specified sources he/she wants to work with. The rest is all about execution and adherence to laid-out standard procedures.

Let’s move on to some group issues. Kindly share the genesis or the requirement for a separate entity like KCL (100% owned by you) in addition to the listed entity KGL?

This was a situation that was forced on us around 2006. We had plenty of orders to fulfill in KGL but also a stretched out balanced sheet. Bankers were unwilling to lend us the 30 Cr we needed for fulfilling orders on hand. I had no option but to create a separate entity like KCL. I took very high risks. Had to pledge everything I had, all my personal holdings and savings. Even then, no single bank w
as willing to fund us. we finally managed to rope in 3 different banks to fund us 10 Cr each.

This is how it happened. For me there is no difference between the two – it’s like my left arm and right arm!

We understand group capacity is at 5.5 L pieces/day today. While KGL (440 Cr) has higher Sales than KCL (250 Cr) it also sells Fabric. Kindly share the garmenting capacities at KGL and KCL specifically. (ICRA Reports on KCL and KGL cite this at 90 Mn and 65 Mn pieces annually).

TBD

You have talked about doubling the group capacities from 5.5 L pieces/day to 1.1 Mn pieces/day in next 2-3 years. How will this be achieved and what kind of investments will we be needing.

We completed ~70 Cr investments in the Robotics assisted Fabric Processing plant last financial year towards enhancing capacities. The fabric capacity now at 48 MT is sufficient to see us through the targeted garmenting capacity of 1.1 Mn pieces/day in 2-3 years.

Now some more investments will be required towards cutting and sewing machinery. We have already ordered Advanced fully-automated Cutting machinery that will be here soon. Also we have ordered more advanced Sewing machines that are more efficient and will consume less power. Totally some 30-40 Cr additionally for the group. For KGL it will be about 15 Cr.

So, how do you see KCL and KGL growing individually in the next 2-3 years?

Both will double the capacities. Both should keep growing at 20-25% annually.

What about the Employee Base? ~4000 are direct employees at KGL. What is the total KGL+KCL direct employee strength? How many are contracted?

Total employee strength is ~8000. There are no contract labourers.

While capacities are being enhanced what about the Labour situation? will that also need to be doubled ~16000 employees in 2-3 years? And, if you continue to double volume capacities every 2-3 years – realistically, where do we see Labour counts growing to in the next 3-6-9 years?

Actually we will need only incremental 10% more additional Labour to reach 1.1Mn/pieces per day.

That’s something difficult to grasp and will take some doing. Kindly share how will this be achieved?

Firstly productivity improvements through use of advanced technology, backed up by productivity improvements through increasing efficiencies. Thirdly automation is being brought in new areas. For example we are installing a shaving machine that will bring in 4:1 savings in manpower. That itself will free up 300 people. We are bringing in lot of automation in Kitchen that will free up another 100 people. Automatic Roti-Maker (just need to put the Maida) producing 60 Chapaties every minute. Automatic Idly-Maker producing 2000 idlies per hour. 30 kg onions will get peeled in 1 hour. 2000 plates will be cleaned every hour. All imported fully automatic machines being introduced. Imported German machines for Vaccuum Cleaning that will bring in 75% labour saving.

It’s not one single thing that will do the trick, but a whole host of new initiatives in every area that we can identify where we can improve productivity and/or increase efficiency. Together we are confident these will deliver double the capacity at low incremental labour addition.

Okay. But even managing a 8,000-10,000 kind of Labour Force with high attrition is a tough job. How are you handling things today? How do you manage attrition/training/motivation and sourcing Labour?

Earlier we were using local people. But since last 2-3 years that supply wasn’t enough and we had to source labour from other states like Jharkhand, Orissa and other locations. Fortunately we have found a very competent partner who is able to provide us on a regular basis.

However, the Training part is the most challenging. When you went around the factory, you must have observed how disciplined the workforce is – they continue to do their job efficiently, silently. Most people wont even look up while you are passing by except if you are directly at their table.

But getting them to be like this is a big big challenge. When they come they are uneducated, unhygienic, raw folks. There is also the phase of adjustment to Climate and adjustment to Culture, living and eating and even basic hygiene training. Its tough, but today we have the processes to manage this transformation. Don’t see a problem for next 5 years at the least.

So how big a acclimatization-training team do you have today?

At any point of time there are 100 people being trained at Kitex. 15 days off-line, followed by 15 days on the line on the job training. With this 1 month training they are at about 35% productivity. Another 45 days before they get to the usual 60-70% full productivity.

There must be constant outflux too. Normal attrition. plus since its mostly women once they reach marriageable age, etc. When they go on annual leave after a year, many may not come back? How big a challenge is it really as the Labour force scales up?

Yes it is our biggest challenge, but something that is manageable. We are probably doing a better job of it than most places in India. We have an excellent outsourced partner in Don Bosco. DB Tech or Don Bosco Tech mobilises these youngsters and sends for training in sewing to Kitex. Don Bosco has been managing the mobilisation extremely well for us.

The Kitex team takes over and is able to make them productive within 1 months and fully productive within 3 months as mentioned before. Actually when someone goes on leave for a month, they usually return with 5-6 of their own -sisters, cousins, neighbours, relatives – their transformation is there for all to see! [Kitex Training-Corporate Video]

Kindly educate us on the US Wholesale Operations set-up? What are the aims and what is the investment size?

There are 3 ways of entering the US market

A. X or Y Brand manufactured by Kitex (manufactured by Kitex is imprinted on the garment)

C. License some established brand – that is not present in infant wear – take advantage of the mother brand while providing best quality manufacturing by Kitex (again Kitex manufacturing brand is enhanced). In US market Quality comes first (probably even before Brand) hence huge Branding exercise may not be required. Since customers can return products even after few days of use, quality is critical, and we can leverage Kitex quality while piggy-riding on the mother brand.

Is it right to conclude that these are probably longer -term initiatives and that initially the most significant impact will be on timely deliveries and logistics cost savings? What impact is this likely to see on the margins front? and by when?

We have hired some office space in US. We will import Kitex garments in bulk ourselves, pay the landed duty price (LDP) and offer our products directly to retailers. This activity should get started in next 2 months and will help shave off 0.5% of current logistic costs.

In time we may be able to replace distributors in between and supply directly to Retail ourselves. Distributors today are marking up as much as 30-50% off us while selling to retail.

There looks to be a conflict of interest here. Why wouldn’t this strain your relationships with existing customers (like Carter) who also procure in volumes for themselves (their retail presence) as well as supply to Walmart and other big retailers.

No, we do not think so. US is a very competitive but business-like place. If you can get additional business from Retailers, good for you.

Why can’t
a US manufacturer do a good job with more of the automated machines and efficiency drivers like you have spoken of before?

$12/hour is the minimum cost of Labour. For 8 hours this would cost $96, say $100 or Rs 6000 per day. Rs 6000/- per month is the Labour cost in India. Even if someone were to manufacture in US efficiently, who is going to consume products that will need to priced that much higher?

5. PRODUCT MIX

Kindly explain the major product mix components. Baby/Layette, Sleepwear, Play clothes and so on.

Which are the low-value items and the high-value ones? Are there major avenues for value-addition by moving up the quality-chain?

Caps/booties are low-ticket items while Body Suits are higher-ticket items

What are the major sources of growth and profitability?

Body Suits with high volumes and higher realisation at $1.25/piece

Any plans of producing more than infant wear? What about Toddlers 2-4 or say 2-7 years and service the full range of a major retailer like Carter?

Only of there is a (unintelligible hand-notes :-().This 2-7 years segment is much more commoditised market.

6. OPERATIONAL OUTLOOK

6.1 CUSTOMER CONTRACTS

In the past there have been instances where customer‟s product failure (2012-13) or delayed orders from clients (2010/11) has led to order volatility impacting the group‟s revenue growth.

As explained before we experimented with relatively smaller buyers, but that didn’t work out and we have resorted back to the large buyer relationships where visibility is strong and scale and volumes are maintainable.

You had problems with TESCO?

TESCO and another buyer. That was in 2010-2011 time frames

We haven’t incurred even 1 hour production loss in the last 3 years. Our business model now is more stable.

Today how are we safeguarded against problems of similar nature? Do contracts have stringent clauses for guaranteed off-takes/penalties for non-adherence to schedules?

Large buyers have contracted wall space with Walmart – much in advance of the season. Wall spaces like 3 feet, or 6 feet, 9 feet or 12 feet, Wal-Mart is in the business of selling walls to brands. Supposing you are booking space for Mar 1st to July 31st. In addition to the Rent for space, you have to provide a minimum sale guarantee. You have to fill the space in time. If you sell less than minimum guaranteed – you need to pay penalties.

This is not India – where if you have contracted something for Mar 1st, and you can call up and request can I shift to Mar 7th, my suppliers are unable to supply! 7 days of unutilised wall space at any retail outlet in US will carry huge penalties.

How are Order books/Capacities negotiated? How often are these negotiated – 6-monthly or annual process? Are prices fixed or is there some pass through for cost escalation, say with a lag effect?

Usually Orders are negotiated for the Season or 2 Seasons. Spring/Summer and Winter/Fall. No, once a order is negotiated the Price is fixed. Normally while negotiating for the upcoming season, the RM is available at fixed pre-negotiated points for us, and cost is known. Once the order is negotiated, currency hit/gain onus is on us completely as is fluctuations in yarn/other RM.

However in case of any abnormal gains/losses (more than 10%) there can be some passing of benefits from either side in coming season(s). Cotton prices can go up one year and come down the next. There has to be give and take. Both sides have to survive. Only then both can win.

What is the relationship between annual order scale-up and the inevitable margin pressures? How often do you face this?

As explained before, those days are over. The cost structures are known to both sides. Everyone has to survive. Room for some minimal negotiation have to kept – the Buyers/Sourcers have to be seen doing their job. We have mechanisms in-built to handle that.

What are the debtor days norms with major customers? Have there been any instances of debtors going bad with any of the major customers? In last 10 years Debtor days have usually been at ~58-60 days, FY 2014 has seen it at 45 days? Is this a result of any re-negotiations?

Standard Debtor terms are 60 days. For delays we charge additional 0.5% to 1% for 60-90 days. In some cases/new deals we open LCs

Inventory days record has been more uneven. ~60 days in earlier years to 100-110 days post 2010 (RM used to include Processing charges till 2010, why excluded now?) is down to 17 days in FY14 (11 cr vs 45-50 Cr in immediately preceding years. Kindly comment. Is this a one-off aberration this year, or?

Standard inventory days are 45-65 days. You have seen higher levels when we had visibility of yarn prices shooting up. We are improving our Inventory Management processes and trying to bring Inventory levels lower. Lower levels should be sustainable.

6.2 SUPPLIER CONTRACTS

What are your major Raw Materials – Yarn, Fabric? Who are your major suppliers? How many suppliers do you deal with? What is the duration of such relationships?

As explained before, Yarn is the mainstay of fabric quality. We manufacture garments only with superior quality Kitex specified yarn based on Okeo Tex Class I specifications. Yarn is the main RM (50-60% of total RM). Major suppliers are GTM and PBM. Kitex specified superior quality yarn is not available in the general market.

What kind of contracts do you sign with major suppliers? Are they spot-basis, yearly negotiated or long-term contracts with cost-escalation pass-throughs? What is the nature of cost- escalation pass throughs – only currency related?

We have been nurturing 4-5 suppliers (both in North India and South India) for over 5 Years. We offer guaranteed payment for guaranteed volumes. For some of them we have been sourcing 100T/200T per month.

Who are your major technology suppliers? Do you enjoy any supplier credits with them?

We enjoy very advantageous pricing deals – we get all machinery at Cost Price. They are willing to give up their profits as Kitex buying some machinery from them is something of an endorsement for them.

Why exactly are you in that happy situation today?

We are known for our willingness & ability to take risks on using advanced machinery using latest technology. Our technology suppliers take credit in showcasing Kitex factory as a buyer for their latest advanced machinery. They bring customers from all over Asia and even European countries like Turkey to our factory. Every month there is someone or other visiting.

Creditor days have been constantly improving over last 5 years, dropping to 20 days in FY14 (Sundry Creditors have stood at ~24-26 Cr over last 5 years despite the impressive Sales pick up). Kindly explain – why have you been obliging suppliers with such benign credit terms?

Our interest charges work out to be 7.5% whereas our Supplier have to work at 12-14%. We are availing less credit from RM suppliers and negotiating better prices for us.

6.3 CAPACITY

The augmented Fabric Processing Capacity at 48 MT is sufficient for catering to what Garment capacity? 11 L/pieces per day? When will we need the next big augmentation of Fabric Processing capacity – at what Garmenting capacity?

The Knitting and Fabric processing capacity curr
ently should see us through the next 2-3 years i.e. suffice till targeted Garmenting capacity of 1.1 Mn/pieces per day.

Kindly educate on how 90 Mn Annual capacity (KGL) and 65 Mn Annual capacity (KGL) translate to the 5.5 L/pieces per day. How many working days/month or year

Working days are 26 per month, Sundays being weekly off. Add some festival holidays.

72 Lakhs capex was completed in FY14. This was mainly for the Fabric Processing part. Is it correct to say all Capex in FY15 and FY16 will now mainly be for augmenting Cutting and Sewing machines? How much for Cutting machines? How much for Sewing machines?

Yes further capital expenditure will be on Automatic Cutting machines (already ordered) and more advanced Sewing machines as explained earlier (already ordered)

What has been the spend so far in FY15 and what will be the spend till Mar 31st?

About 15-20 Cr

Will we see some augmented capacity in place by 1HFY15? And what will be the likely enhancement by FY15 end?

Gradual ramp-up throughout the year.

What happens to the older machines? For sewing machines that get replaced say, are you able to get a good price or they are more like scrap?

Our accounting depreciation rate taken is ~8%. But Heavy machinery have a practical life of 20 years. Even Sewing machines – we are not using any Chinese machines. We have been using robust Japanese machines, where initial investment is very high, but these have a practical life again of 19-20 years.

We are able to get a decent price. a) A new sewing machine say today costs $800, roughly the same it used to cost when we originally purchased on $basis. b) while purchasing our $-Re equation would have been at Rs 35!

How often do you need to replace machinery?

In our experience, we have seen it is better to replace every 5 years. One, it straightaway leads to a 10% increase in efficiency. That allows us to get more productivity out of the labour-force – something that we are quite focused on.

Net-net, what would you say is your Return time frame for investment in machinery?

6.4 SALES

FY14 Q1 Sales came in flat at ~100 Cr. Was this more due to the ongoing technology/ automation initiatives pursued by the company that required extensive trial runs as also the stabilisation of the enhanced Fabric processing capacity?

Mainly attributable to seasonality in Sales

Kindly explain the seasonality experienced in Sales during the quarters? Why?

For US and Europe, Spring/Summer and Winter/Fall seasons- that’s how the Buyers procure. Fall/Winter sees heavy buying while Spring/Summer is slower. Spring you get only about 1 month of Sale, while in Summer you get 2 months of Sales (holiday season). So barring some exceptions, you will see that Q1 is always slow, Q2 is better, Q3 is heavy, and Q4 super heavy sales.

Kindly share the contribution from government subsidies, duty drawbacks and other export incentives?

What is your average cost of Capital (Debt Funds)?

Term Loans – 12.5% currently. But we are expecting will come down by atleast 0.4% to 12.1% or so as our credit ratings have been revised 2 notches up by ICRA from A- to A+. We may be the rarest of the rare Textile company to be rated A+ – most Textile companies are at A- levels or lower (about 750 Textile companies are rated today). And better still our Bankers – State Bank of India have upgraded us to SB2 from SB4 (SB1 is the highest rating).

7. RISKS/CHALLENGES

Would it be correct to say that the Marketing challenge is over? It is now mainly an Execution challenge in stepping to service demands from global customers?

You can say that.

What are the major challenges before the organisation?

Today Labour training/controlling is the only real constant challenge. We are in a comfortable situation on most other fronts.

What is the take on lack of geographical diversion – both on customer front and manufacturing front?

While US is still the largest market, all major customers have a growing international presence. As explained before, Middle East and Asia are growing very fast. In the next 2-3 years we will see more business from every buyer from these regions.

Manufacturing wise, we have no foreseeable plans to locate another plant elsewhere.

Why is the Political Risk not real or negligible in your eyes? Everyone says Kerala is a very difficult place to do business in.

That is mostly perception (misplaced). Those days of business-unfriendly political and labour environment are long gone. Today Media is very strong, development oriented public opinion is strong, people are much more educated.

Every year we contribute 700 Cr of valuable foreign exchange to the state. We are already the largest employer in Kerala. This would not have counted for much in bigger states, but Kerala is a very small state. The political establishment – all mainstream parties – value our contribution to the state.

Yet you yourself have faced protest and delays in clearing expansion plans in the past. While coming to your factory we saw hoardings of Panchayat and SDPI – citing some details against Kitex?

We have not done anything wrong. We have never violated any laws of the land. We pride ourselves in adhering and bettering every environmental or social compliance norms/laws. There are no issues with mainstream political establishment. This was a small outfit called SDPI who are always trying to create trouble, in order to extract something. But we have handled that in our own way.

Why are you confident this cannot/will not repeat again – there will not be any production stoppages or some charges slapped unfairly on other grounds of say – women workforce exploitation – the bogey that SDPI raised?

For that you will need to understand the genesis of the problem, our determination in weeding out the problem, and our process behind the same.

This all started in 2012 in June by a local outfit called SDPI – (Wikipedia Link) – they controlled the local Panchayat at that time. Our environmental license was up for renewal and they started making hugely exorbitant demands. Naturally we refused.

They first raised the environment pollution bogey and ran a mis-information campaign against us. They enlisted local villagers support (we had minimal local contact then). Their attacks got more and more personal and made me to be seen as a villain and a criminal, vilified me in every manner possible.

One way is to acquiesce and pay what they want. Keep on paying bribe/sleaze money and work without any problems. But I have been seeing these things – seen my dad suffer from the time when I was in 1st standard.

But now we had the resources to mount a serious challenge at the very roots of the problem. For a normal fee of x, if someone puts up an extortion demand of 10x, we can spend 100x to quash the problem once and for all.

The problem was our lack of contact and strong support base within the local village community then. I started local contact myself. I went direct to the people and explained how my father brought me up, inculcated the discipline in me, so we could create something like Kitex in your village. I explain
ed my vision for the village, how every child can be taught the value of discipline, and aspire to achieving the best in life. Fortunately people listened to me, staying on in rain for hours, and urging me to speak on every time I wanted to stop. They wanted to hear me. Meeting went on for 3 hours non-stop, people came out in large numbers to hear. Opposition also conducted meetings – attendance started to become thin -if they had 50 people gathered, our meetings would have 5000! [lots of footage shown to us].

Soon, we conducted a signature campaign. In one day we collected 16000 signatures!!

We started conducting cultural programs on Onam festival for the region – with 25000 people in attendance. We went to schools in the region and sponsored their football teams. Today we support 40 football teams of schoolchildren – soon we will have our world-cup [laughs]. We have conducted all types of awareness programs, invested in projects for drinking water supply, and the like.

We want to make this village a model village – example of the best, anywhere in India. This is the third year of engagement. we have the complete support of people in this village and nearby villages.

Today if I stand for elections, I will win easily. Opposition will lose their deposit.

Some might question if this is not bordering on over-confidence? And, you are so passionately involved now, it will be fair to question whether your priorities might change – after all you are the key man for Kitex?

[Smiles] This work/passion is properly scheduled. Sundays and after 5 Pm. Also on holidays. Kitex is always remain the first priority – that is business.

All this must have been very frustrating for you, also depleting lot of your energy?

With every opposition, I have only grown. What is Life without challenges?

8. FOREX/HEDGING

There is no stated Forex/Hedging policy outlined. We are watching the situation very closely and have taken adequate measures. We hope to show some decent gains

9. DIVIDEND POLICY

What is your stated dividend policy?

Again no stated dividend policy. But we will show steady, stable growth in dividends. We must ensure there are no dips.

As companies get comfortable on the debt front and there are stable cash flows, mature companies have a fixed/target Dividend Payout in line with the Earnings growth. What is your thinking on that front?

We are not yet a mature company. We have taken very aggressive bets to reach here.

Our first target was to become debt free. You can say we have reached zero debt level only now, if you account for the Cash. Whatever Surplus we generate, we need to ensure enough to save us on a rainy day. What if there is a crisis next year, what do you do?

There are external pressures (from shareholders), but I think we are right in resisting those pressures till we reach a situation where we can be called a mature company.

10. Kitex Garments Ltd and Kitex Childrenwear Ltd

Minority shareholders like us are however concerned with the listed entity KGL. In the current scheme of things, concerns on Management discretion and Corporate Governance will always remain. Why not merge the two?

Yes Merger should happen at the appropriate time.

One needs to appreciate that we are in this situation, because of historical reasons, as explained in detail earlier. You must also appreciate that there is lot of value creation still to be done at KCL level. I have staked everything I had on this entity (taken on very aggressive bets) and merging the two at their current stage will be really short-changing myself and my children. When KCL business and Clientele grows to a certain level, merger is surely on the cards.

What kind of value creation are you looking at?

First, the business in KCL has to grow to a certain level. It has to independently demonstrate the track record of sustained growth on the back of sustained customer relationships. Once that level is reached, it will be easier to envisage for anyone whether KCL can go the next level or not. That will be the right time to merge the entities.

You already have significant holding in the listed entity KGL. Purely from a financial gains standpoint (notwithstanding the value creation) – Investing community likes to point out Merger of the 2 entities looks unlikely because with Promoter shareholding is capped at 75%, you lose more.

Yes, we appreciate that.

So, you are saying you don’t mind that minority shareholders getting benefited more?

Yes. It should be a win-win situation. Shareholders in the company should also benefit

But Actually minority shareholders (of KGL) are walking away with a good chunk of the value creation in KCL for free, while you stand to lose that chunk of value creation, in the merged situation. There would be other gainful options for you, surely?

There will be value unlocking in both the companies after the merger, the combined entity valuation will benefit everyone, so even if I give away some to minority shareholders I too stand to gain.

An objective assessment of this situation would point to the above inequity and suggest that KCL acquiring KGL is the more likely outcome – after the Value Creation.

Not going to happen!

Taking that argument line, one can say I can do anything with KCL – I am the only owner. But KGL is a listed entity – there are other significant shareholders, one cannot just walkover them. Any decision taken can only be arrived at after due process. Only proposals that can carry everyone and convinces everyone, can be taken for KGL.

Disclosure(s)

Ayush Mittal: More than 5% of Portfolio in the Company; Holding for more than 1 year; Tirumal Rao: More than 5% of Portfolio in the Company; Holding for more than 1 year; Pratyush Mittal: More than 5% of Portfolio in the Company; Holding for more than 1 year; Anil Kumar: More than 5% of Portfolio in the Company; Recent Entry;

Management Q&A

1. AGRI INPUTS

1.1 OSHEEN – DINOTEFURAN INSECTICIDE

As you are aware Osheen is a 3rd generation systemic insecticide invented in Japan by Mitsui Chemicals Agro Group (MCAG). PI Industries has registered and developed OSHEEN for the Indian market, in collaboration with Mitsui, Japan.

OSHEEN has been trusted as a most reliable solution to effectively manage the Brown Plant Hoppers in Rice for number of years in the leading Rice growing countries. It has also been tested and recommended by leading agriculture research institutes of Govt. of India on Rice crop and Cotton crop.

You are known for registering/introducing in-licensed products only after proper gap analysis. Is it correct to say OSHEEN is a uniquely positioned product, just like Nominee Gold was?

Yes of course. OSHEEN has been introduced through due process – has unique advantages of longer control period and better coverage. Because of its unique mode of action OSHEEN effectively controls the target pests which are not controlled by other molecules.

So what additional benefits does it bring when compared to other competing Insecticides?

OSHEEN has fast action due to which target pests stop damaging the crop after coming into contact of OSHEEN and start dying within few hours. It has systemic action and quickly gets absorbed into the plant, effectively killing the target pests present in the different parts of plant and provides longer and effective control on targets pests. OSHEEN has trans laminar action due to which spray done on the upper surface of the leaves gets translocated to the lower surface and controls the target insects hiding on the lower side of leaf.

But then it must be a more costlier product?

See you must realise for Farmers its not about a BRAND. For him the only thing that matters is cost of application/acre, and there OSHEEN delivers much better than many competing products.

So there has been enough efforts on farmer education?

Yes.

What about Data Protection? How many years will it have an uninterrupted run?

Well it has the usual 3 year data protection as per Indian laws. Post that a generic me-too source may be eligible to apply – depends on how good the product is. Even with a good product, effectively it will be 4-5 years before any effective competition emerges.

Any co-marketing efforts already on?

That will come later. First OSHEEN needs to be seen to be delivering the goods.

1.2 NOMINEE GOLD

Kindly update us more on Nominee Gold. You had allowed co-marketing of the brand with other MNC/innovative agrichem partners? What are the results?

As you are aware we had enetered into reciprocal co-marketing arrangements for Nominee Gold with a few MNC players. That allowed us access to some of their brands for co-marketing by us. We entered into these realtionships after due evaluation for optimising product portfolio in certain markets to offer complimentary product baskets. Results have been encouraging so far.

But you have also extended co-marketing to Rallis & Dhanuka too? Aren’t you diluting the BRAND if its available from everyone? What’s the deal there?

Again we evaluate these things from a relationship perspective too. They have reasonably big distribution network in certain regions and It ensures our presence in those markets.

You had mentioned last time if PI were to try and cover the whole market it would take us 10 years. Co-marketing would allow us to increase visibility and allow us faster coverage in 4-5 years? How far has that played out? How much additional sales has been generated for the product through co-marketing?

Should be 15 – 20%

Rice Herbicide penetration was mentioned last time at 5% levels? Where is that now?

It should be ~8-9% of total rice acreage.

So there is growth possibility definitely for next 4-5 years?

Much more than 4-5 years of good growth.

Now that Data Protection for Nominee Gold is over, what about emerging competition?

That was over last year itself. Few Companies have applied. It will take time before we see effective products on ground.

1.3 IN-LICENSED VS GENERIC IN-HOUSE PRODUCTS

In-licensed vs Generic products. Is the current ratio still 60:40?

It is about 65:35 right now

You had mentioned that this ratio will rapidly change, by now you had predicted 80:20 actually; going upto 90:10 eventually

That’s true, but take into account last year. Because of the pretty bad last year, we got behind. We should be there in the next one or two years.

You launched 2 in-licensed new products. Kindly educate us about In-licensed Pipeline vs Competition. What’s the process? How do you keep abreast/ahead?

We have ~8-9 products in development pipeline and several others at negotiation table. This is a continuous process and our Competitive Intelligence mechanisms giving us inputs long before products are actually out in the market. Our process cannot depend on assessment of pipeline of others. As you are aware, we have very strong in-house gap-analysis MIS culled from all over the country for prioritising our pipeline.

What’s the price/revenue mechanism with In-licensing Innovators?

It’s based on simple long term purchase contracts. We purchase the Raw Material – active ingredients or formulated product.

What’s the pricing strategy for new generation in-licensed products?

As mentioned before, end of the day the farmer has to see lower of application/acre and therefore, your product price proposition should be attractive for him.

There are quite a few new breed of competing products like Round Up and others. What kind of threats do you see for your product lines?

We think there is room for all to grow. We focus on identifying a gap and providing better yield/productivity for the farmer.

What kind of impact do you see of the Food Security Bill? Is that a positive?

This to my view should drive food production, productivity and yields have to go up substantially. Farmers will get incentivised. If Farmer is happy, we will be happy.

You have lot of exposure to the Rice crop. First through Nominee Gold and now Osheen. Have you seen much of Hybrid Rice? Is that growing rapidly? What’s the potential?

Yes this is true. However, Osheen is also doing well in cotton. Also we have several other products in fruit, vegetables and other field crops. Hybrid seed is rising and so is the research seed. Next wave of growth in seed may come from corn.

2. CUSTOM SYNTHESIS (CSM)

For the first time we have seen CSM overtake the Agri segment. Revenue Contribution in FY13 was 55:45 CSM:Agri. How long before this scales to 65:35? Strategically, is this a great development?

It’s certainly good to see CSM scaling up the way it has done in the last 2-3 years. However for us it is important to be able to grow both segments equally well. For two reasons:

1. This gives us a neatly de-risked/balanced business model
2. Agri segment – the domestic opportunity is huge. It’s a very low-capital intensive business. Given the strength of our model and the strength of the agri-business sector in India, this segment is poised for 30-40% kind of growths over the next 3-5 years horizon. This segment provides us the CASH to fund the scaling up of the CSM business.

Give us a sense of the split between Long term contract vs annual contracts in CSM?

~60% is in Long Term contracts while roughly 40% get negotiated annually.

And the Long Term Contracts are all guaranteed off-takes model?

Yes, Take or Pay.

You have cited deliberately not expanding $300 Mn order book (static for 2 years) – for flexibility in accommodating higher value/volume molecules that had some visibility.

That’s right. Keeping the Order Book at an optimum level gives us the flexibility to balance investments required for sewing in long term contracts for say 10 years. Accordingly you need to invest in plant for tapping new opportunities.

So any success there?

That is what you are seeing today. The ramp up is from that success. We had promised 30% but we grew by 60%, isn’t it. This is happening because we have retained the flexibility.

14 molecules in Commercial stage. Please give us a sense of the longevity of Molecules – new vs old?

Both old and new molecules. Some have been there for long. Some have dropped off to be replaced by new molecules. That is why you need the Pipeline.

Pipeline of 28 molecules. With a 40-45% success rate you hope to see 10-12 going to commercial success? Is it right to say you have pipeline that provides visibility for next 4-5 years?

As you know Pipeline keeps getting refined on a continual basis. We have a robust Pipeline is what I can say.

Please give us a sense of existing Customers. How many in Commercial stage and how many at R&D/Pilot stages?

Yes Divi’s Labs has EBITDA margins of 30-35%, but Asset Turns <2. PI has EBITDA margins of 20-25% with Asset Turns 2.5 to 3.Things should be seen in that context.

You have today ~600 Cr coming from 14 CSM molecules. Is that ~40-45 Cr per molecule?

(Laughs). Well different molecules have got added at different stages. They come in different sizes. Having said that it’s not so skewed also as say 2 molecules contributing 500 Cr and rest 12 contributing 100 Cr.

Sony-PI/Update?

Nothing new to report.

Why are your R&D expenses so low compared to other players?

If you are engaged in innovation research/ANDAs your R&D costs will of course be at higher levels. We on the other hand are involved with process research where costs are much less.

3. JAMBUSAR

We are starting to see good contributions from Jambusar. But project is delayed by 2 to 2.5 yrs?

All delays are attributable to delays in getting pollution clearances and the Environmental Clearances.

Given the 10 yr tax concessions already underway, is there a focus to ramp up subsequent phases?

Of course. We are already doing erection work for next phase.

First phase took 2 to 2.5 years. What’s the timeline for commercialisation of next phases?

May be 9 – 12 months.

Sterling SEZ progress. Would you say there are any risks to progress?

None at all. As you are aware Gujarat is a very progressive state. Everything is progressing normally.

We have already reached 90% utilisation at some 100-120 Cr. What happens to Asset Turn targets of 2-2.25x?

(Sighs). One must look at the total investment versus investment for Phase1 and then compute Asset Turns. Our existing Asset Turns are greater than 2.5x. Going forward you will see these numbers. Projects will come/being negotiated with these figures in mind.

What are you Long Term Debt goals. Do you intend to become Debt free in future? Interest Costs will continue to be low

Yes, that’s the goal. Interest costs will be low.

With Free Cash flows flowing in, are there inorganic moves being planned?

Yes, we are investigating.

We were visiting companies across Gujarat and came across your Panoli facility. We couldn’t help notice the severe smell/pollution?

We are not in the Perfume Industry, you know. (Laughs, from all around).

Did you notice it all along the highway? or only along our plant. This is a common feature across the belt.

So aren’t these things monitored by any Agency?

Let me state that India is at least 10 -15 years ahead of China in this aspect. We have been having very stringent norms since the last 15 years.

Gujarat Government has evolved even more stringent norms. There is online monitoring of air stream and water streams.

So how significant are the Pollution control/Environment Management Risks for your business?

We are at risk only if a) we are not adhering to Norms b) not investing to manage pollution/effluent levels. Environment Management is the largest component of our Costs.

—————————————-END OF DISCUSSION—————————————————————————————–

Disclosure(s)

Ayush Mittal: No Holdings in the Company; ; Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 2 years; : ; ; : ; ;

Background

Shriram City Union Finance (Shriram City) established in 1986, is part of the nearly four decade-old Shriram Group, and has its origins from the needs of the Chit Funds customers. The company started operations with truck financing. In October 29, 1988, the company became a public limited company and renamed as Shriram Hire Purchase Finance Ltd. In March 1990, City Union Bank Ltd. acquired shareholding 200,000 shares at par. Consequently, the name of the company was changed to Shriram City Union Finance Ltd. The company registered as a deposit taking asset financing NBFC with RBI and went public in 1994.

Prior to 2002, the company was exclusively engaged in transport finance with special emphasis on financing pre-owned commercial vehicles to small road transport operators. In 2002, the company discontinued the truck financing business (except for trucks > 10 year old) as that business was consolidated in its sister concern (viz. Shriram Transport Finance Ltd) and started as a separate business unit in year 2002 as Shriram City Union Finance Ltd. Listed on BSE in 2003.

Today Shriram City offerings comprise finance for Two Wheelers and Three Wheelers, Four Wheeler Finance (both new and pre-owned passenger and commercial vehicles), Personal Loans, Small Business Loans, and Loan against Gold. This has made Shriram City the only NBFC to offer such a wide range of products under one roof.

Vision:Serving the under-served. Creating value at the bottom of the pyramid.

High Capital Adequacy – With the recent Capital Infusion, CAR at ~23% is the highest in the industry. Tier I Capital is at a comfortable~18%. This should be adequate to fund growth for next few years

High growth trajectory -While FY14E AUM growth will be muted – partly due to Loan Book recast and partly due to disruption in normal business in AP due to Telengana protests, next 2-3 years could see 25% CAGR growth

High Yields look sustainable – SCUF has the highest yield among similar NBFCs at ~22%. Given improving Product mix, yields likely to stay high

Operating Costs likely to come down – SCUF Cost to Income ratios had been climbing up mostly due to Employee expenses shooting up over last 3 years – from ~6% of Expenses in FY11 to over 13% in FY13. This was largely due to integration of Shriram Chit Employees into its fold (From ~3000 to just over 19000 in 2QFY14). With the process getting completed and conservative branch expansion targets hereon, this is likely to stabilise and head downwards in next 2-3 years

Valuations – Given the strong positioning in its niche, SCUF appears to be trading at reasonably attractive 2.2x P/B valuations (CMP 1030)

Bearish Viewpoints

Concentration of business in AP & TN – 80% of business currently comes from these 2 states with AP (48%) and TN (32%). Any disturbances and/or policy change in the key states could impact business significantly. The ongoing Telengana issue and protests had seen disruption in normal business activity and had affected disbursements to MSME customers. The impending bifurcation of AP and likely protests means SCUF remains vulnerable to disruptions again – and that may impact growth

Asset Quality seemingly deteriorating (Advancing recognition Norms)

SCUF

SHTF

Chola

Sundaram

MMFS

Bajaj Finance

GNPA

2.4

3.2

1.0

1.0

3.0

1.5

Recognition Norm

150d

180d

180d

120d

150d

90d

SCUF’s NPA’s are on the higher side. This should also be seen from the context of significant share of Gold Loans (with low NPAs) in Loan Book. However to be fair, Recognition norm at 150d is conservative and keeping ahead of RBI stipulations/timeline.

Advancing Recognition Norms/Standards Asset Provisioning may be raised – As per Usha Thorat Committee DRAFT Guidelines, NBFCs may have to move to 120-day NPA recognition norm from April 1, 2014 and 90-day norm from April 1, 2015. Also Standard Asset provisioning may be raised to 0.40% from 0.25% effective March 31, 2014. This may lead to higher costs on provisioning impacting earnings. Eventual write-offs though could be lower (nature of customers/business). As per Management, in the entire 28 years history actual delinquency is <1-1.5%.

Barriers to entry

Chit Model – 90% of the current business/addressable market is mostly insulated from competition. For its target segments a Shriram Chit customer will go out of the group only if SCUF is unable to meet the customer requirement

Strong Brand Equity – “Shriram Brand” has high brand equity within its target segment – leading to low spend on advertising in both existing and new geographies

Interesting Viewpoints

Leveraging/Piggy-Riding on parent/group – Shriram City Union completely leverages the groups strengths – Customers, Database, home-grown systems and processes for the self-employed, and IT systems. Expansion to newer geographies can be incrementally calibrated by piggy-riding on group ecos-system and branch network, with minimal capital outlay

Regulator view of NBFCs turning favourable? – Even 2 years back regulatory risk may have been cited as a key risk for NBFC businesses. However of late RBI is seen to be shifting its hawkish stance (as evidenced in say the recent Comprehensive Financial Services for Small Businesses and Low Income Households Report chaired by Nachiket Mor, Central Board Member, RBI) and acknowledging the key role and value-added contribution that NBFCs could make towards financial inclusion in India. Also recent 23 Jan 2014 Speech Non-Banking Finance Companies: Game Changers, by P. Vijaya Bhaskar, Executive Director, RBI

Only 7% of MSMEs seek external sources of credit, the rest managing with self-financing or with funding from informal sources. MSMEs have a total finance demand of Rs. 32.5 trillion, of which only 36% is widely considered as addressable by financial institutions. The remaining 64%, ordinarily considered unviable because of inadequate/poor credit profiles, preference for debt from informal sources, reliance on self-financing etc. presents a rich potential for NBFCs if adequate safeguards can be built in to protect asset quality[Source: Ministry of Micro, Small and Medium Enterprises, Company AR, MSME FInance in India IFC Report]

Shriram City for the most part caters to the Micro Enterprises segment. Their research indicates that in the event of the GDP growing between 4% – 5%, the MSME sector should see a long term growth of between 15% – 20%. [Source Company AR]

Shriram City Housing Finance – Incorporated as a fully owned subsidiary in Nov 2010. Currently 76.5% owned by Shriram City and 23.5% by Valiant partners. Focusing on Tier 2&3 cities and the under-banked with average ticket size of 10 lakhs, this business is at a nascent stage with Asset size of ~340 Cr as on Sep 2013. Growing rapidly with disbursements crossing ~215 Cr in Sep 2013 up from 40 Cr in Sep 2012 – a building block being laid for future disproportionate growth?

Disclosure(s)

Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 6 months

Para IV = These are allowed to be filed – post 5 years of a NCE patent grant by USFDA for a generic version of the Innovator drug

Para IV FTF = 180 day exclusivity = Para IV First to File is another category where even before the first five years are over a company can challenge. If approved that company gets an 180 days exclusive approval to market its generic version of the Innovator drug. This can prove very lucrative for the challenger if granted. On the other hand there are Litigation Risks where the Innovator tries to prove that the challenger has infringed on its patent/process while developing the generic version.

Then there are what are called NDA filings – under which 505 (b) (2) falls.

505(b)(2) = larger period exclusivity = These are meant for a bio-similar, but completely new product. It’s made from a different salt and/or a totally different process. The FDA in its discretion (depending on the benefits/costs of development) awards a higher exclusivity period. For example for our NDA Desvenlafaxine Base Extended Release (bioequivalent version of the innovator drug Pristiq by Pfizer) was approved with a 21-month exclusivity.

What we understand is that Para IV, Para IV FTF and %05 (b) 2 filings are the most lucrative. They also carry Litigation Risk. Can you give us a sense of the proportion of Para IV and above filings among your cumulative ANDA filings?

Initially there were Para II & III also but increasingly this mix is in favour of more complex Para IV filings.

Any of the Para IV FTF are Solo?

None, at the moment.

Why have you chosen/not able to commercialise some 30% of your approvals?

Most of them due to API issues (not available/changed) or another DMF is now used. In one case product was found to be unviable.

How are you able to comment that future mix of filings is skewed towards Para IV and above ?

Well things like Sample Seeding for the products, preparing batch stability files, etc have to start ~3 years before filing. We are already working on the pipeline for FY 16-17-18-19

NDA Desvenlafaxine Base Extended Release – 21-month exclusivity, approval received in record 10 months. Congratulations for this super-achievement. What is the progress on this launch through Ranbaxy partnership?

What is key here is doctor conversion. Doctors are currently used to prescribing Pfizer’s Prisitiq – they have to be educated about the availability of our generic version. It happens faster when our product starts appearing in the approved product lists of some of the large insurance companies. It will take 4-5 months before an on-the-ground assessment can be made.

What kind of price erosions are expected? is it true that you will see a 40-50% price erosion immediately?

For the Succi Desvenlafaxine product there were 11 FTFs approved. However for Desvenlafaxine Base Extended Release product we are the only one with 21 month exclusivity. We should not see more than a 20% price erosion in 1st year.

And in next year?

May be 30% price erosion.

Can you share the revenue share arrangement with Ranbaxy for Desvenlafaxine?

No comments.

———————————————————————————————————————-

What’s the update now on Desvenlafaxine {Jan 2014}?

It is ramping up. But not upto expectations.

What are the issues?

Well we found out that patients using the innovator drug Pristiq on a regular basis – which is indicated for the treatment of major depressive disorders – are very reluctant to change the drug (generic version, even if cheaper). Someone (suffering depression before) who is now able to lead a normal life with regular Prisitiq medication isn’t going to risk lapsing back.

So what are the learnings from this whole episode? You had such a blockbuster technical breakthrough, but seems like not too much will come out of it.

We have taken it in our stride. These things happen. We have moved on.

On the other hand we have seen a 100%+ growth in this segment in 9mFY14 with Sales doubling to ~329 Cr. What is this attributable to?

This is a result of a 2 pronged strategy. Building up on Contracts/Order Book and scaling up on manufacturing. We had a bulging orderbook, but were seriously short on manufacturing. Augmented capacity started becoming available only post July last year. The swift ramp up is on account of that.

1.3 INTERNATIONAL GENERICS – TEAM/MARKETING/STRATEGY

You had decided to set up your own Marketing Network in the US? How difficult is it going about this?

This is now the biggest challenge before the company. We are galvanised behind making this a success. This whole effort will take us the next 2-3 years. The first results are atleast 1 year away.

This is a major effort. What will be the costs? Will it be around 10-15% of Sales or higher?

What are the costs? Mostly salaries and the sales+distribution costs. You should see it like this. Most of the Profits were being given away to the ANDA guys. Compared to that we will be incurring a fraction of the cost.

Kindly give us a sense of the leadership behind this strategic PUSH into US Market and the success in the International Generics business that we are seeing.

The whole International Buisness initiative is driven by Mr Pranav Amin our Director and President International Business. He is very dynamic and is pushing everyone forward with aggressive plans. He has not hesitated to bring in the right people with high salaries.

We have an US CEO who has been with us for last 5 years and assembled together a top Team in International Generics business. Success has come because of ProductIdentification ability. Year-wise market-wise plans are drawn up till 2024. We have to create very detailed Product Identification Files or PIFs. 8-9 people get to sign off – IP guys, Marketing guys and Strategy guys. And we believe next 10 years success will also because of this.

What about Litigation? How confident are you in handling the attendant Litigation Risks that come with an aggressive ANDA filing strategy?

We have built a strong IP Culture/Team over last 5 years or so. This Team comes up with identified products. Multiple Legal opinion is taken from 4 specialised Large US Attorney firms. Only if it is considered safe, we proceed.

Despite this caution if Litigation comes up?

There are always other options. If we subsequently find risks are high we need not go for a confrontation route. We can offer our product with royalty/other options.

Alembic has always been known as a pedigree company. But this aggression is new-found? While this culture may now be top-driven, what about the Team? How will the old Teams adapt?

Technical Team is 100% new – All IP/Research Team are new imports form other large organisations with relevant experience. On the strategy/marketing side there are a few top people who are new and a mix of folks like us.

———————————————————————————————————————

2. INTERNATIONAL BRANDED

Kindly take us through the International Branded business. Does it cater to the ROW Markets?

Products are the same as our domestic branded formulations. Yes this segment caters to the ROW Markets like Russia & Africa.

Is there a country specific branding/sales strategy or it’s the same brands across geographies?

It’s the same brands being marketed in every country.

Competition must be intense in these countries as most Pharma companies from India have a significant presence in these markets?

Yes there is lot of competition. But we have formed a new team focusing on this segment.

We have seen a ~48%+ growth in this segment in 9mFY14 with Sales reaching ~46 Cr. Is there any focus to make this segment a significant contributor to topline and bottomline?

This is a 50-60 Cr Annual market. There is more focus. More filings – which also means more investment. Earlier filings cost $5000 , now these cost as much as $25000-30000.

What is a sustainable growth rate for the next 2-3 years?

We should see 25-30% kind of growth or 100 Cr in next 2-3 years.

———————————————————————————————————————-

3. API

As we understood from you last, this is a segment that is completely fragmented, intensely competitive, and if weI remember correctly you planned to get out of this segment. However this is the segment showing highest growth by 20% over FY12. And thus increased contribution to Sales from 7 to 8%. Kindly comment

The API segment (Acute therapy) that we were present in is very competitive – it is in turmoil. Chinese products have flooded markets world-over and India is no exception.

We have done 2 things a) Shift Focus on our own products – increase Captive use b) Shift focus to cater to large pharma company ANDA API requirements – become their first or second source. We have seen successes on both these fronts.

So move has also been away from domestic market API requirements to developed Markets?

The focus is 95% geared to servicing our ANDAs (captive use). At the same time we are able to utilise this to service large pharma company requirements for EU and emerging markets also.

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4. INDIA BRANDED /INDIA GENERICS

India Branded formulations

1HFY14 Sales
Contrib

1HFY14 Sales

Alembic Market
Share

Alembic Annual
Market

Alembic Growth

Therapy Growth

Alembic FY16E
Sales

FY16E Contribution

Anti-Infective

36%

157.2

3.99%

314

3%

2%

334

28%

Gastrology

18%

78.6

2.50%

157

16%

9%

212

18%

Cold & Cough

12%

52.4

5.08%

105

11%

11%

129

11%

Cardiology

11%

48.0

1.43%

96

38%

13%

183

15%

Gynaecology

9%

39.3

2.08%

79

29%

7%

131

11%

Orthopaedic

5%

21.8

1.14%

44

8%

7%

51

4%

Anti Diabetic

5%

21.8

1.32%

44

31%

24%

75

6%

Opthalmology

2%

8.7

1.67%

17

51%

8%

40

3%

Nephro / Uro

2%

8.7

1.84%

17

37%

14%

33

3%

It looks like fast growing Specialty segments like Cardiology and Gynaecology are set to overtake the earlier dominant segments in a few years. Kindly comment

Ealier Anti-Infective and Cold & Cough segments used to account for 80% of domestic sales. Now this is down to 50%. Yes Cardiology and Gyneacology are growing fast and will contribute bigger share in coming years and will overtake some segments like Cold & Cough pretty soon. But the Investments needed are high.

What kind of investments? Is it correct to say this is a Marketing driven game and not so much on the technology side?

Absolutely, all investments are in Marketing. We need to ensure Quality and availability/mind share with Doctors. Form a very low base we have started growing the specialty segments. Fortunately Alembic enjoys a very very good brand equity with Doctors. Brand recall is very high, so we are trying to cater to higher margin lifestyle disease segments. This strategy is paying off, as doctors are ready to accept new drugs quickly due to brand name and trust.

India Generics- some 86 Cr in 9mFY14? Why do we need domestic generic Sales? Is this profitable?

Well this is a ~100 Cr annual market for us. Some of the products here are negative margin to upto 10% kind of margins. Instead of the brand name drug, it is sold in the generic name. There is a big enough market for this in smaller towns. In a way it takes care of some of our fixed costs by generating additional sales. If we don’t sell it, somebody else will and take this.

5. SOURCES OF PROFITABILITY

Operating Margins have seen a consistent uptick? What are the main sources of profitability?

The uptick in profitability is due to a few things.

1. Improving Product Mix – As mentioned before, we decided to shift focus and get out of Domestic API which was acute therapy focused and volatile. Anything less than 15-18% EBITDA we decided to get out of.

2. Shifting focus on Formulations – Both Domestic branded and International Generics

3. Process/Efficiency improvements

The depreciating Rupee also helps to an extent

How sustainable is this going forward?

This is set to continue for the next few years. Product mix improvements are already significant. We are able to leverage economies of scale with new plant. We are at ~20% EBITDA levels. There will be 1 to 1.5% margin improvements every year for a couple of years. In a few more years we could be in a different orbit.

—————————————————————————————————————–

6. RISKS

What in your opinion are the major risks?

Regulatory Compliance. We are taking this very very seriously. When we were small it was easy to manage. But as we scale up we need to ensure systems and processes that take care of ensuring quality.

Kindly give us a sense of how seriously this is taken by Top Management?

The normal practice in the industry is to employ 1:2 Quality:Product personnel. At Alembic we are maintaining a 1:1 Quality: Product personnel ratio. We ensure everything is on the SAP ERP system. We have built a strong Quality Team.

When the Board meets, the first item on the Agenda is USFDA Compliance. And usually it takes 3-5 hours.

USFDA Inspections? Is this like a sword now hanging over Indian Pharma companies having/attempting a presence in US markets?

Not really. Some reactions/rumours spread that this time USFDA folks are coming to shut down 20 plants – that’s all nonsense. US has to rely on Indian manufacturing plants – we have the largest base outside of the US. Yes, they have very objective, very detailed worksheets. If there are some observations that come out, well they are not going to suppress them.

When did you have your last inspection? Were any queries raised?

1.5 years back. No queries were raised.

7. R&D SPEND

Likely to stay around 6-7% of Sales

8. WORKING CAPITAL MANAGEMENT

27% sales to 20% of Sales, to 17% of Sales? Debtors 62 to 47 to 56 days?

This is mostly on account of the API shift.

While Inventory levels haven’t changed much – implies that Payables also has improved significantly. What are the reasons?

Driven by Operations team focus. Some KRAs (Key Result Areas) demanded are to increase 30 days payables to 45 days and 45 days to 60 days.

9. CAPEX/CAPACITY UTILISATION

Till when will current capacity suffice – FY15? When Next? Quantum

Actually we should be able to see through FY16 on current capacity. We are introducing a lot of automation at an initial cost of ~40 Cr.

What kind of Outsourcing do you resort to? What is the quantum?

India branded – Roughly 40%

10. FOREX/HEDGING

Simple 3/6 month forward contracts.

11. TAXATION/TAX RATES

20-21%

12. DIVIDEND POLICY

30-35% Payout.

13. MAJOR CHALLENGES

Next 2-3 years it is the US Marketing Challenge that will consume us.

Disclosure(s)

Ayush Mittal: Less than 5% of Portfolio in the Company; Holding for more than 6 months; Vinod MS: No Holdings in the Company; ; Hitesh Patel: More than 5% of Portfolio in the Company; Holding for more than 6 months; Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 6 months;

Management Q&A

1. THE BUSINESS, INDUSTRY & OPPORTUNITY SIZE

Kindly explain to us the key guiding tenets for your business. How exciting is it to be where SCUF is today?

As a group (Shriram) it’s in our DNA to look at Financing segments – where they find it difficult to get financing – typically the Self-Employed (non-salaried class).They face a shortage of credit – the formal Banking sector is not much interested in them – as they can’t provide salary slips or proof of regular/future cash flows.

But this does not mean we jump into every opportunity in this space. There must be SCALE and MARGINS must be PROTECTED. We get in when a) it is difficult to do b) there are higher margins adequate enough (for the inevitable bad eggs in the basket).

How important is the MSME space in overall scheme of things? How difficult or complex a business is this?

Success in MSME financing business is pretty simple, actually. It’s a plain vanilla labour-intensive game. There are 1000’s of middle level executives involved. It is their persistence and sweat. It will be wrong to say there is a big “classy” process behind this. It is the labour and the humility to relentlessly chase for collections. There is a process for sure, but that process is in building people (like a factory) – who can stay true to persistence and sweat and humility to chase – each situation is different! 80% of our success can be attributed to this patience and diligence at the branch level and only 20% to Intellect-driven systems/processes.

MSME financing is important. We have a dominant position in the small loans segment. MSME pie of the Loan book has been increasing. From over 35% a year back it is now at ~50% levels. It could reach 70% of Loan book in 2-3 years. Gold Loan has come down to ~25% levels – this business we will be doing at our own pace – we are certainly not getting out. There is also 2Wh and Personal Loans which are doing well. Depending on the environment, we will take our calls, we will be nimble.

How well-placed is SCUF in MSME NBFC funding space? When do we see Banks/FIs addressing this space in an institutionalised way?

Banks are not very active in MSME funding where the Risks are higher. When they do fund they are mostly funding “Manufacturing” businesses unlike us where our share is more on the “Services” businesses.

What about PSU Banks? And Credit Guarantee Shemes from the MSME Ministry where funds are available for upto 1 Cr without collateral.

Well these schemes have been there since almost a decade without much of an effect. Our sense is that Bankers are inherently uncomfortable lending where there is no collateral (as recourse to recovery is generally poor in our country). They are not well-trained to study and evaluate or rate a small business that can’t offer much by way of collateral. PSU Banks are used to the Customer coming to them for Loans. They are not used to go to the Customer (save Deposits). Look at the turnaround time – in CGSH schemes and in general practice, is 6-9 months. And then some of our customers tell us – the effective cost is the same.

Where does SCUF see itself 5 years from now vis-a-vis current competition?

We should do 20-25% CAGR over 3-5 years. As & when the economy spurts, we will also do better.

“Scalability” ( how long is the runway? What are the assumptions for growth for the next 3/5/10 years? Can you actually grow outside home base? ) and “Repeatability” (Can you simply keep doing more of the same and what could hinder this – i.e. Recruitment, training, technology, competition poaching etc. )

Scalability – In terms of opportunity there is space for even 100 players to step in and everyone can grow. We are only scratching the surface in terms of what we have touched so far. However this is hard terrain – Not everyone can step in and do what we are doing, as successfully.

Repeatability – As explained before, yes the whole thing is about repeating the same labour-intensive dogged pursuit of collections. At our core, we are an out & out collections company with humility, persistence and sweating as the key cornerstones for our success.

What do you see as the biggest threats to your growth plans? e.g. government regulatory changes, etc.? Is increasing regulatory oversight a good thing/bad thing in the longer term?

We have a feeling things are changing at the regulator/RBI level. They are more willing to listen. The recent RBI report on Financial Inclusion chaired by Nachiket Mor actually speaks highly of NBFCs and the useful role NBFCs can play in India. There is lot of new ideas being brought in by eminent people like Shikha Sharma and Vikram Pandit and others on the panel. Even 2 years back, things were difficult. Now we are very hopeful that things are changing, the regulator will start playing a more positive role.

Our biggest risk is our own execution. As we scale up we should remain glued to the groups conservative ideals, processes and systems. That we do not fall prey to foolhardiness – cutting corners or taking shortcuts. The Economy has slowed down, credit is tight. A growing economy will help us scale faster.

You have applied for a banking license – what impact will this have on existing operations?

Let’s make it clear that we have made a conditional application. Because of our understanding of small business, we believe we can significantly contribute to financial inclusion aims of RBI and Government of India. As our group director has said recently, we won’t pursue our aspiration to become a bank at the cost of our existing business, but only if RBI is willing to support and facilitate us to lend to these segments appropriately.

And what’s the take on Shriram Housing Finance? Do you have big plans there?

Our plans are very clear. It will take 3-4 years before it becomes significant. As mentioned before we don’t do anything that CAN’T SCALE.

2. OPERATING STRUCTURE

Kindly brief us a little on operating structure and major business processes? Why do you have 2 MDs, to start with?

Basically different skill-sets. Mr Sundararajan – MD – ex CMD Fullerton – he is the public face of the company – he meets the press, regulators, media.

Mr Duruvasan – MD – he has been there for last 35 years+ with the group. He joined after +2 level and got his degree by attending night college. He started as a collection executive in chit fund and rose to be its ceo. He was also MD Shriram Life Insurance.

He is a great leader and visionary. Much of what Shriram group is today can be credited to him.

Kindly tell us a little more on his early years, achievements and leadership style?

To give you a perspective in 1990 Shriram TN business was 10x AP business size. In the next 8 years from 1990-1998 he built up the AP business to 2x TN size. He is a great man with an eye for talent – right person for right job – and building teams.

From 1990-96, we used to add ~9-10 branches per year, as we had good teams throwing up good leaders. But from ’96-’99 we added ~25-30 branches every year. Team was flush with talent – we needed to accommodate ~75 people who had grown capabilities for next level of leadership within the teams.

Shriram chits acted as a distribution arm as well. We used to distribute CDs/Mutual Funds. People developed multiple skill-sets – market development, debt collection. Even today Shriram Life Insurance derives 70% and Shriram City over 45% of its business from AP.

Back-Office/IT systems/Risk Management

Entire Back-office, ERP, IT facilities including Centralised Cheque Printing facility is based out of Chennai.

CTO & CAO – Chandrashekhar. He is a cost accountant with IT skills. He handles all our home grown IT/ERP systems. The internal audit team reports to CAO as do the Account Heads at branches.

Business/Strategy – Front Office

Operations HQ is Hyderabad and Business handled from respective regions.

COO – Y S Chakravarti – He handles Operations. The Business guys and the Credit guys report into the COO. The Product heads at branches report into the COO.

And Region-wise there are CEOs for TN/AP/MH and also for North and another for MP, Chhatisgarh, Kerala and Gujarat.

Role Clarity – Accountability

Roles are clear as is the accountability. In his own area, each is a MD, which also means no one can hide behind anyone’s back. There is no overseeing that is needed. No Senior Management reporting/briefing is necessary. The MD usually needs to meet Operating Heads at Board Meetings only. We are all home-grown, grown up on the job- with the business. We are like family comfortable with each other, with clear individual/team goals set for us.

3. MAIN BUSINESS MODELS

You have the MSME CHIT model running in AP/TN/MH primarily referred from Shriram Chits. Kindly brief us on the key characteristics.

CHIT Model -South

As you are aware this is primarily in Andhra Pradesh, TamilNadu and Maharashtra with Shriram Chits customers primarily. This has a run-rate of 250-300 Cr per month. Average ticket size ranges 10-12 lakhs. Some are in 18-20 lakhs. Maximum lending is upto 1 Cr. This is mostly secured business. In AP it is 65-70% secured.

Did the Telengana stir disturb normal operations?

Yes it was affected during that period as normal business was disrupted. However it is back to usual once the protests are over.

You are trying to replicate this same CHIT model in North India?

CHIT Model – North India

We are trying to replicate this CHIT model slowly in North India over last 2 years with small loans. Average ticket size is 2 to 2.5 lakhs. This is kick-started by mining our 2Wh Customer database. Small business owners like Stuffed-toy makers, Ice-Cream makers, Trinket manufacturers. In 2 years time this now has reached a run-rate of ~2 Cr/month.

Also you are trying out basically the regular (NON-CHIT) NBFC MSME funding model in North India.

External Model – North India

We decided to step into the regular CIBIL credit-scored MSME financing model in a slow cautious way, 3 years back. We recruited experienced executive level senior people for the job who in-turn recruited fresh talent for building the Team. In 3 years now this segment’s run-rate has reached ~20 Cr/month. Average ticket size is 20-22 lakhs.

How are you looking to scale this probably important segment?

This has been a learning phase for us. We are extremely cautious here as this was a completely new turf. One cycle of lending and closing is over. The Team is doing very well. Net NPAs are <0.2. Lending Caps were <1 Cr till now. Only recently this has been enhanced to <2 Cr. We don’t have any branch/numbers driven expansion targets. Our philosophy for expansion is – when we have next rung of capable people (home-grown) ready to take on branch leadership roles, only then. Maybe 2-3 years down the line we will have a good crop of capable leaders for expanding presence.

You have been integrating employees from Shriram Chits into SCUF fold now. Is the process complete? What are the overlaps now with Shriram Chit Fund?

OVERLAPS with Shriram Chits

Shriram Chits also plays the role of a distribution arm from group company products, also for SCUF. Employee integration from Shriram Chits is now mostly completed. Any shared office infrastructure (with Shriram Chits) is now owned and run by SCUF, shared by Shriram Chits.

4. MAIN BUSINESS PROCESSES

How do you employ customer knowledge from chit fund history? How is it used operationally? Is there a formal score? If not, how do you prioritise or incentivise better track record customers?

Customer look-up can be done from the Database. It can provide some rough pointers. We have what is called a CHIT Rating system. Customer consistently paying within the month (actual payment date is by 7th) are tracked. Very simply put, any customer with more than 15 installments paid within the month is considered credit-worthy.

When a Loan turns non-performing, what recourse do you have, how do you go about recovering?

We don’t have Big Clients (Big Defaults). Big Clients are not even approachable much of the time. And when you do reach them the refrain can well be “Business/Economy is not doing well. What can I do? You come back when business cycle recovers”. Small clients have an ingrained honour system. They want to preserve their reputation. Our people are able to sit with them in their house and work out a deferred plan (usually they are willing to pay the penalties for late payments). Payments get deferred, but rarely turn delinquent.

What kind of skills-profile do you require for these jobs?

We don’t need MBAs and financial experts. Normal graduates can do the job. We need local people familiar with the terrain. Understanding the customer comes first. People who can understand the customer, work on the relationship, gain their trust and imbibe the groups ethics of humility, persistence and sweat.

What kind of training do you equip employees to deal with – say the tough collection process?

It’s mostly on-the job! Our Management Trainees go through more than a year of exhaustive on-the ground training. Usually it’s baptism by fire from day one – collecting money from tough clients, with monthly reviews.

How do you create the right incentive structures? Loan growth vs profitability vs Collections?

First of all nothing in our business is outsourced! The one who sells/lends also collects. 60% of incentives are aligned to Sales and the balance 40% for Collections.

What about Manager level/Executive level Incentives?

For the Branch Manager it’s is an aggregate of different product lines – MSME, 2WH, Gold. Average of incentives collected by Teams under him. For the Divisional Manager again, it is an average of the Branch Managers reporting into him. Likewise for Zonal Managers.

Any discretionary powers in the Loan Hierarchy?

Not really. The only discretionary power is on the Processing Fees side – some 2% at Account Head levels – marked as deviation – requires Approval.

What is the experience over last 3/5 years versus last 10 years and is there is any clear trend? On collections and recovery of bed debts, say?

In our entire history (28 years+) Collections at Loan Termination has been over 97%. And 6 months from date of termination collections are 98.5% -99%. So terminated arrears are 1%-1.5%. Greater than 180d NPAs are <0.5%.

5. RBI GUIDELINES AND NBFC BUSINESS

Kindly explain the current guidelines and its impact on SME business

Well these were proclaimed in 2012. We have learnt to adjust. As you might have seen we have been keeping ahead of the RBI timeline. We have advanced our NPA recognition norms to 150d from 180d.

As per the DRAFT RBI guidelines, NBFCs may have to move to 120-day NPA recognition norm from April1, 2014 and 90-day norm from April1, 2015. Also Standard Asset provisioning may be raised to 0.40% from 0.25% effective March 31, 2014. Kindly comment how are you prepared for this?

NPA recognition norms may move from 360d to 180d to 90d but as explained before, in our DNA we are a collections driven organisation. There will be delays, but hardly any delinquencies. Our customers are rarely defaulters.

Unlike say Banks (10x leverage) or NBFCs (upto 6x leverage) or even a Manufacturing Enterprise (3x leverage) a small service/trading business capital structure is usually the reverse. It is 3:1 Equity:Debt and in most cases 5:1. The intention to pay is there (as is the capability). Capital is always large (as compared to debt). Unless they have 5x losses they are able to service the debt.

So what kind of impact will these have on earnings?

TBD

What about the Securitisation cap impact?

While Securitisation may be the cheapest source of funds for us, does not mean our other source of funds are not okay. Securitisation is not a panacea. You must also look at the time factor involved – 9 months of seasoning vs instant availability. Today because of our reputation and Shriram groups standing we can have immediate access to Funds. If we require 900 Cr, we can get it.

Because of further restrictions on NCDs, etc. dependency on banking sector will increase? to what levels?

See as a group, we have access to comparatively lower cost Funds. Today we are at 15,000 Cr. Shriram Transport has already shown us the way to 50,000 Cr. Let’s reach that phase first. We believe we can reach there in the next 5-6 years without much issues. We can worry about next level of scalability then. By that time Shriram Transport might show us the way to 100,000 Cr.

6. MARKET MAP/COMPETITION

Give us a sense of your market? How is the competitive scenario?

Market is huge. This is just the tip of the proverbial iceberg we have touched. There is room for more than 100 players if need be. We are really in competition with the customer (to accept debt).

Bajaj Finance and some others do Loan against property business for small business and get yield of around 13-14%. They classify it as MSME business. Isn’t that competition?

Loan against Property (LAP) is a different segment – the loan is secured against the property with lower yields like you mentioned. Most NBFCs who mention MSME financing are actually doing only LAP products.

So how is a LAP product different from MSME Financing?

LAPs are usually longer duration products. The customer is typically saying, I have a property. Unlike in our business where the customer is more likely to say I have a business…and I need a loan for my business for 6 months to 1 year (or 2 years).

Is it correct to say ~1/3rd of your MSME loan book is secured which is ~17% of your overall Loan Book (MSME Loans at ~50% of Loan Book)? The question is how do you compete effectively? Are your yields much more comparable to LAP rates for this segment?

TBD

7. FUTURE GROWTH/PROFITABILITY DRIVERS

Shriram Chits customer base is your biggest strength. It also enjoys very high reputation with your customer base. Your customer acquisition costs remain low on account of this. But somehow “Chits” business generally has got an adverse image in India. Kindly comment.

There are some rotten eggs in every sphere in India. CHIT as a product is best suited for a country like India. CHIT is used both as a savings product as well as for borrowing for business. Sometimes by the same individual for different needs (savings for his wife) and the borrowing Chit for his business purposes. CHITS were popular even in China, Africa and Italy.

Is it correct to say Shriram Chit fund has ~ 3Mn customers? Is it correct to say currently more than 90% of MSME customers are through Chit fund customer database?

How much of this Customer base is already addressed for SCUF product portfolios? How much is still virgin opportunity?

Not more than 20% perhaps. So one can say 70-80% is still available for fresh addressal.

And this is a completely protected base – that is unlikely to go out to seek their financing needs?

Shriram group brand equity is very strong with this customer segment. This segment of customers are very keen on “who’s the lender?” Normally for our target product segments, they are unlikely to go outside to seek financing.

What is the overall growth expected in next 2-3 years? And MSME Loan book proportion expected?

Next 2 years may be tough for the economy. Having said that, we are probably better insulated than most, because of our diversified but niche product bases. We should be able to do 20-25% CAGR over next few years. MSME Loan book proportion could touch ~70% as we have both width (<50% branches currently offer) and depth (penetrate deeper into existing branch customer base) to explore.

What’s the broad mix of SME business which are being financed in terms of %?

We are completely industry agnostic. One can say we are more focused on Traders/Service Industry than Manufacturing industries.

How much of growth will be driven by higher penetration and how much from geographic expansion?

Growth will come from deeper penetration of customer base at existing branches and widening our presence. We have more than 1000 branches today. MSME Loans are currently offered at ~50% of the branches.Gold Loans at 70% of branches and 2Wh Loans – the earliest Loan product is offered from ~80% of the branches. More than 200 branches are shared locations. Incremental growth will also come from shared office space with group companies. We can expand reach at low incremental cost by putting up 2-3 people at shared locations without much capital outlay.

Plans to expand branches outside AP & Tamilnadu over next 3-5 years?

As explained before, we do not have formalised branch expansion targets/plans.

To what extent political disturbance in AP is impacting your growth in MSME loans?

It was only for that period of protests. Now operations are back to normal.

Because of the increasing mix of higher yield and higher tenure MSME Loans (vs Gold), is it likely we will see a higher margin picture in next 2-3 years?

It is possible. But we have to see that the Gold Product had lower NPAs. Net ROA is likely not changing much. Post-tax RoA should remain around ~3%.

8. DIFFERENTIATION/OTHER NBFC MODELS

Do you see any benefit in developing specific industry expertise, relationships with machinery OEMs? And priortising/focusing based on growing industries, leveraging the machinery relationships, funding machinery assets?

As mentioned before, we are completely industry agnostic. We have a dominant position in the MSME Small Loans funding space. We are doing well in 2Wh and Gold Loan space. We see opportunity size before us as huge – we are just scratching the surface.

Any NBFC having such differentiation – how valuable is that expertise in the long term? Would you go so far as to say this is highly valuable and may create niche dominance in SME asset financing?

Definitely there is value for specific industry expertise. However one has to weigh the scalability front. Funding machinery as opposed to funding Individuals – Entrepreneurs. Besides there is lot of merit in product diversification of the kind SCUF has. Any mono-liner (including SHTF) product has to go through stress some time or the other, is inherently more risky.

Which are some of the other NBFC models that you admire?

Mahindra & Mahindra Financial Services. They have done a good job with rural penetration. REPCO Home Finance and GRUH in the Housing Finance space are other commendable success stories.

Disclosure(s)

Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 6 months; Tirumal Rao: No Holdings in the Company; ; Davuluri Omprakash: No Holdings in the Company; ; : ; ;

Management Q&A

1. OVERVIEW

Your company has had a spectacular journey. Kindly give us a sense of how you see the Medical devices business, and Poly Medicure’s place in it.

There is a huge opportunity still to be tapped. From our participation/co-charing in several industry bodies like the CII we are siezed that medical benefits/availability is constrained near the top. Yet to percolate down to the masses.

Non Communicable Diseases (NCD) is a 6 Trillion $ market for next 20 years. NCDs like Diabetic/Cardiac/Cancer care will be a focus area. There will be a shortage of Services and Service producers (Doctors & Nurses) for next 40 years.

80% of medical devices are still imported. Generic devices that can be manufactured are still not being manufactured in India. While custom duty on imported devices is low, ironically duty on imported RM (plastics) is being hiked. Manufacturing in India is not highly incentivised like in China where you can have all approvals/agreements in place within 3 days.

Give us a sense of the Medical Devices/Technology Business, and opportunity from India? And Poly Medicure’s place in it?

Medical technology is a $3 Bn annual market and that includes MRI machines, Xray machines and even Stents.

All leading OEMs are looking at manufacturing out of India. There are huge distribution networks that are looking at outsourcing manufacturing from India. These people are looking at Polymed – as a leading manufacturer of a basket of products – IV Cannula, Safety IV Cannula, Blood Bags, Catheters. We are manufacturing something like ~95 different products, today.

Even if 1% of that global market is outsourced from India that’s a $300 mn market (as compared to $25 Bn of China).

Kindly educate us on your business segments? Given what you have shared above, OEMs must be a big focus area?

We have 3 verticals. Domestic, Exports and OEMs.
We are among the Top 3 in local market. We have recently invested in expanding the Haridwar facility for the domestic market and focusing more on the local market. Domestic business currently is only about 50-60 Cr, rest is Exports. We plan to scale up domestic business significantly.

OEM vertical is our focus area. We plan to scale up this vertical significantly. As mentioned before there is interest being shown by lot of global players. Let us see what emerges.

Kindly give us a sense of globally how we are placed. Who are the main competition?

B Braun, BD, Hospitec, J&J, 3M and Poly Medicure are among the main players. By next year we could be among the Top 3 after B Braun & BD.

2. SAFETY DEVICES

One of your major successes has been the patent challenge with B Braun on Safety IV devices. Kindly educate us on the challenges and opportunities that this throws up? How significant is this for Poly Medicure?

B Braun is one of the largest players in the Medical devices/disposables field. Safety IV devices itself is globally a $300-350 Mn annual market size today. This was a 20 year patent granted in 1999, so is valid till 2018.

We developed a novel process/mechanism for manufacturing the Safety IV Cannuala which we believe is non-infringing. We have been successful in the patent challenge in many markets like Germany and India. We have also lost in some like Malaysia and injunctions have been placed against us in Spain, recently.

There is a big opportunity to grow globally with that product range. We don’t have a foot on the ground abroad in many important markets. We will have to grow cautiously, step by step – our pockets are not deep.

So what percentage of Sales is Safety Devices likely to grow to?

10% of Sales is where we are – can go upto 25% of sales eventually, in next 4-5 years

3. OEM RELATIONSHIPS/LEARNINGS

You have been supplying to OEMs and pursuing the OEM relationships in a big way now. What has been the learnings?

There has been big learnings in terms of Knowledge acquired and the approach followed by the major OEMS. Learning on knowhow – how to improve systems and processes have been huge. There is much to learn from how the global majors go about developing Vendors. With more exposure we are incorporating Global Best Practices in the organisation.

4. INCREASING AUTOMATION

You have been making significant investments in Automation. Given the labour situation is this a likely trend we are going to see going forward too?

Yes, we have recently invested about 50-60 Cr in automation that should serve us well for next 10-15 years. There are several advantages to increasing automation. We can maintain 24/7 product lines with ease. As human intervention reduces, we are able to produce a better consistent product each time. Process and output monitoring is very high with automatic alert/escalation mechanisms that get built in. All of these result in higher quality.

At the same time, increasing automation may decrease your cost arbitrage/competitiveness with major players like BD?

We will still be far more competitive than BD. Much of the automation has been achieved through home-grown machinery.

5. ORGANISATION BUILDING

Kindly throw some light on how the organisation is gearing up for the challenges ahead. What kind of structures/processes are you putting in place?

We are fortunate to have a Core Management Team that is exposed to best practices in the world. We had engaged E&Y for improving on our processes. They have completed a study of all our processes and delivered complete SOPs (Standard Operating procedures) for all the departments. And are now engaged in creating proper DOA (Delegation of Authority) and Management by Objectives procedures.

The next 50 leaders in the company are being prepared.

6. CONFIDENCE – AT ALL TIME HIGHS?

As the company has started turning in Stellar results, there seems to be huge confidence all round. You are shrugging off the shackles of the recent past. Kindly comment

Yes. Last few years we walked with heads low as we struggled to come out of the forex derivative contracts issues. We managed to successfully put that phase behind us by focusing on things within our control – bringing in process improvements and cost-efficiencies wherever possible, plugging leakages and cutting wastage.

Consequently as you would have noticed, our margins are much higher. We expect good cash flows for next 2-3 years. We are actively looking at JVs and/or acquisitions.

7. PREPARED FOR THE MEDIUM TERM?

While the organisation seems quietly confident and gearing up for a promising future, how prepared would you say you are – for harnessing the opportunities before you?

We are fully prepared on all fronts. as you know the biggest factor in India currently is Land/Infrastructure – this is something that can be a real dampner for growth if not available, at the right time. We are fortunate that with our Jaipur facility and the additional land available at IMT Faridabad, we are secured on this front for the next 5-6 years.

We can do a 20-25% Organic growth easily for the next 5 years.

8. THE CHINA FACTOR

What about the China vs India manufacturing Edge? How do you see us placed today, especially in the context of your industry?

The main difference is in Raw Material and Labour situation prevailing in the two countries. Raw material (plastics granules) are today more or less at global parity. However while China Labour rates have crossed $300, in India Labour is still available at $100 levels.

Also with the recent Rupee depreciation going from 45 to 65 vs $, that’s a 40% plus depreciation. We should retain a 50% cost-arbitrage situation for next 2 years atleast.

9. LONG TERM FUTURE

How do you see the Future for Poly Medicure?

10 years from now, we will be selling Products/Knowledge/Patents. We will be much higher in the value chain. Even with higher escalations on the costs side – manufacturing + RM – we will still be making good money.

10. NEAR TO MEDIUM TERM OUTLOOK

Jaipur SEZ completion – by Mar 2014. Is everything on schedule?

Yes. We should be ready by March 2014.

What has been the impact of recent hike in Duties on plastics granules RM?

We also get RM import at concessional rates because of our exports. So there isn’t really much of an impact.

What is the current debt level and where do you see it for FY14?

Total debt should be below 50 Cr levels around March 2014

Given that much of Jaipur Capex has been funded through internal accruals, Interest costs for the year, likely to go up only marginally above last years 6 Cr levels?

Yes. Should be around 7.5 – 8 Cr

What about Depreciation spend for FY14,?

Should be below 16 Cr, or so.

Disclosure(s)

Ayush Mittal: More than 5% of Portfolio in the Company; Holding for more than 2 years; Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 6 months; : ; ; : ; ;

Management Q&A

1. READY FOR THE FUTURE

“While we have been posting sound performances year after year, we have also been working on laying the foundation for delivering consistent growth in future as well. And this year was no exception. We are working on every aspect to be ready ‘For Future’.”

This years annual report is singing a diffrent tune – Purposeful, much more Confident! What’s going on? Kindly comment.

As mentioned in the Annual report, the strategies for growth have been – identifying right products, development of products, regulatory approvals, expanding markets, launching of new products in the existing markets, augmenting manufacturing facilities, supplementing team strength, tightening our belts on finances, etc.

The foundation for this current journey as you know, was laid 10 years back when we consciously moved away from primarily dependence on OTC (over the counter) brands to a prescription-led niche branding/growth strategy for specialty segments. We tried to find our own slots and build on our own strengths, rather than play the volume driven game where everybody was in.

What you are seeing today is the result of a deliberate strategy on above lines – we were content to grow slowly, methodically, step by step. If we can ensure we grow at 20% on a consistent basis we are happy with that. We would rather walk solidly than try and run fast and end-up falling flat.

As a philosophy that sounds good. But on the ground you are not walking – you are running, and running fast. You have continued to grow at 40% plus.

Well the results you see today is because of the foundation laid in the last several years is very solid. We are growing stronger by the day in our markets and in our respective niches. You can say we are enjoying the fruits of the hard work and investments of the last few years now – but we continue to walk solidly; we are not running.

Top 45 Pharma Company in India. You are making making rapid progress in climbing the ranks – from 60 to 50 to now 45. Where do we go from here?

Yes our brands are growing in strength. Our rankings have improved. But beyond a point it is difficult for our kind of niche market/products. Below 40 ranking is almost impossible to achieve.

One last broad question here, before we move to specifics. While other pharma companies of similar size and similar market presence have been struggling/or faltering, you seem to be some way ahead. What are the reasons?

Two reasons:

a) We have always stayed away from Temptations. We have never been in a hurry. As mentioned before we are happy with a 20% consistent run rate. Growing just for growth sake brings its own pressures.

b) Decisions have been based on home-grown strategy/judgement. Not from any Compulsions from – Industry Peers, Bankers, or Investors/Investment Community

2. NEW PRODUCT LAUNCHES/EXISTING PRODUCTS STRATGEY/UPDATE

19 new /4 first to market products. This is where Ajanta used to excel was the key source of growth in domestic markets. The pace seems to have slowed down. Kindly comment

Yes, new product introduction process is more difficult and takes more time now with new set of DGCI instructions. Earlier it used to take 8-12 months, now it takes up to 24 months.

So when you say you you are working on every aspect (now that new product introduction takes 24 months), this would imply you are working on making product pipelines much bigger, than before?

Right, we are ready with much bigger pipelines now.

Existing WHO Malaria program winding down. At 130 odd Cr current run-rate, the impact will be significant?

We derive about 135 Cr annually from Ant-Malarial drugs. Of this 100-105 Cr is the WHO funded component and balance is from the private market. Now its not correct to say that the program is being winding down – will get reduced maybe – its more a re-allocation of funding from available donations at WHO. It really is a function of how much donation is attracted for this program. last 2-3 years there have been noises about this getting scaled down – but funds have been allocated. Even last year they announced funds at the fag end as last minute donations poured in. This year they have cleared funds for upto Dec ’13.

So what is the proposed re-allocation for?

Earlier this was for ‘Adult” malaria control. Now the focus is shifting towards controlling child- malaria. We have already got approvals for ARTEFAN dispersable tablets for this. IPCA Labs is the other one.

So what kind of impact are we factoring in?

We are working at growing the private market in a significant way, we will otgrow this soon. Our next 2-3 years projections do not factor this in.

New PfSPZ Malaria vaccine under development – from Sanaria?

That’s under development, and in no way connected to our existing products

No, not at all. This is not significant for them at all – as you know they are not challenging the revocation in our market. Infact we like to maintain good relationships with Allergan – they are one of the largest players in Opthalmalogy. In 2005-6, Allergen had bought the license for a Opthalmalogy combination product innovation from us for a small sum, in order to gain faster access to market.

Assume there was enough legal/commercial due-diligence before the patent challenge? You were pretty sure that the odds were on your side?

Yes, due diligence was done.

Viagra Sales Emerging/Europe/Total Market. New approval for 11 countries. This was Ajanta’s claim to fame in the earlier days. How significant a share is it of current revenues?

This is one of our oldest products/brands. Normal 4 pack tablet used to be sold for Rs 30 versus the Rs 600 Viagra. We also came out with several innovations – Jelly mode we were the first to introduce, effervescent mode, thin strip, etc.

It is already being sold in 14-15 countries. The UK-MHRA approval allows sales in 11 new countries. At one point of time Kamagra used to be 25% of sales, today it’s no more than 3-4% of Sales.

What’s your reaction to the counterfeiting allegations?

We have been selling locally from many years back. Deemed exports have been taking place ever-since by other parties buying from us in India. Now what they do after buying from us is not our concern, really. Charges/allegations have been there for years unfortunately – but never proven.

Shs24 billion court suit ($9.6Mn)

TBD

3. EMERGING MARKETS STRATGEY/UPDATE

What are the main markets?

Asia, Africa, Latin America, ROW

Kindly educate us a bit on Exports Sales/distribution/segments/products strategy for these markets.

We follow the same Branded Generics strategy for all our markets. Branding is country-specific, and we have invested in building up these brands slowly from scratch in each country.

Today we have a significant presence in these countries as well. As per IMS data we are the the 3rd largest in Philippines after Torrent Pharma. We are the 8th largest in West Africa.

380+ specialized field force. So this is entirely field force driven prescription-led model again? Or there is some distributor presence as well?

No distributors. Entirely our field-force. Earlier we used to have 3-4 guys per country, this is now upto 20-25 guys per country. In India the process is more intense – market reps have to visit the doctor every 15 days, whereas in these markets meeting once in 3 months works. Reps have grown from 250 to ~400 in last 3-4 years.

What about the product/segment strategy/ Are we following the India model in most markets?

Its geared towards what works/is needed/competitive gaps in each market. For example, East Africa is almost entirely anti-malaria market – 95% of which is WHO funded. West Africa has a private anti-malaria market besides anti-infectives, anti-biotics as well. Middle East we have presence in premium antibiotics and premium anti-infectives. Latin America is more a Gastro and Cardiac market for us besides some OTC products. South East Asia has developed Opthalmalogy and Cardiac markets as well. West Asia, CIS are important markets.

So it’s very country specific, and brands built over last many years of hard leg work in these markets. With 380+ professionals and 1500+ product registrations in hand, we are in a good position to strengthen our presence in these markets.

How will further growth be accomplished?

Building on this strong foundation is key. We have over 1200 product dossiers awaiting approval. more than 300 product dossiers will be filed in coming financial year.

Mauritius & Phillipines subsidiaries. Special mention has been made in this years AR. Please tell us more.

Together the subsidiaries have contributed ~ 91 Cr and some 11 Cr in PAT. of this Mauritius contributes the bulk ~70 Cr and Philippines about 20-21 Cr. Philippines subsidiary has grown very fast – doubled in last 2-3 years. From here on these subsidiaries will grow steadily and will be key going forward.

4. US – ANDA FILINGS/STRATEGY UPDATE

This is an important market for us. We hope to have 8-10 products commercially launched by FY16. Apart from the 12 ANDAs awaiting approval (including 5 filed in FY2013) we will be looking to file 6-8 ANDAs every year building a differentiated product pipeline encompassing niche opportunities.

Risperidone – the first product launched commercially is a psychiatric drug. Are we going to see more from the psychiatric drug family?

No. 8-10 products from different segments. All niche opportunity products.

So the strategy remains as before – go for differentiated niche market products. Which also means volumes/sales are unlikely to be very big here. Is that right?

That’s right.

So what kind of revenue contribution are we expecting in the long term from here?

10-12% of revenues over the long term

If we remember correctly this was more from a geographical risk diversification strategy. But the recent hikes in USFDA filing fees and other costs may be needing much higher investments now?

We have already filed for 14 products. For new filings we evaluate from all angles. Filing fees are actually the smaller of the costs. Its the raw material/Innovator samples that sometimes found very costly – from a few thousands to a few lakhs just for the sample.

Increased USFDA Scrutiny. What’s the impact?

We are watching, learning day by day.

How confident are you of facing any further, say un-announced scrutiny?

In 2009 we got our first facility USFDA approved. Since then we have been re-approved twice – each time without any single query raised. The last one was in Oct 2012. Even our ANDA filings were approved within record time of 16 months.

5. R&D SPEND/PIPELINE UPDATE

What kind of R&D budgets do you have. Any allocations as %of Sales say?

Our R&D allocations are influenced by our requirements – on as needed basis. Allocation spends are driven by requirements – such as for filing 12 ANDAs in the year, additional R&D capex requirements, new building needed to house more people or extra storage/lab space required, etc. We aren’t influenced by or follow any fixed percentage allocation process.

What kind of R&D Team do you have in place? What kind of skill sets?

R&D Strength of 300+. We have adequate skill sets/people for our kind of requirements. 10 PHDs, 30-40% are post graduates and rest are graduates.

Who is heading this function? what are his credentials?

R&D head is based in US. He is a highly experienced professional from a big-pharma company He is an Indian with us from the last 6-7 years heading this function.

How are product/market strategic decisions taken?

We have our Directors Yogesh Agarwal and Rajesh Agarwal looking after US and RoW markets. They are constantly in touch with the market meeting distributors, meeting doctors assessing requirements on the ground and have been nurturing these markets for a long time and ensure full sync with Technical functions. Today we have a great R&D Team fully in sync with Business Heads delivering and executing as per laid out strategies/plans.

6. CAPACITY UTILISATION/NEW CAPACITY/OUTSOURCING UPDATE

You had announced the Rs 400 Cr Capex plans quite some time back. The $65 Mn ECB approval has been with you since more than a year, yet you haven’t drawn on these funds. Looks to us plans are delayed/deferred?

Not at all. All our plans are exactly on schedule. We will have the Dahej SEZ facility for Regulated+WHO markets in 18-20 months from now, by April 2015. Civil works are currently on and will be completed by October this year. Machinery is being ordered.

2015 June will see first phase of commercial operations. Initially it will cater to RoW+Domestic operations while we go for necessary approvals. We have the Paithan facility approval experience to back our efforts.

So is it correct to say you haven’t drawn on the ECB funds because internal accruals have grown faster and sufficed?

That’s correct.

What’s your current outsourcing levels?

35-38% outsourced to 40+ vendors/manufacturers

Since your new facilities are still some time away, we are looking at much higher outsourcing levels?

In the next 2 years, we will be probably at 50% outsourcing levels

But this is going against your avowed policy of reducing outsourcing for achieving better control over quality and deliveries?

Today we are #5 in Ophthalmology and #14 in Dermatology and all that is completely outsourced. The aim is to achieve 70-80% reduction in outsourcing once the new expanded facilities are in place.

7. DEBT POSITION/ECB WITDHRAWL/FUNDING UPDATE

Since machinery, equipment will need to be ordered soon, it looks like in 2HFY13 you would need to draw on the ECB funds?

Could be.

How much would you be drawing in the first tranche?

Not more than $20 Mn

8. FOREX/HEDGING

Please educate us on your hedging policy/strategies.

We do not take a call on the direction of the Rupee – that would be pure speculation and open to its pitfalls. We protect a portion of our net exposure by taking simple forward contracts.

9. WORKING CAPITAL

With the kind of growth being registered by Ajanta, we were expecting some slippages on Inventory and Debtor levels. We find on both counts there is huge consistent improvement over last 5 years – down 40-50% levels. Kindly comment.

Debtor levels we will certainly maintain. Inventory levels may go up somewhat. You are seeing these improvements as a result of our brands gaining strength and volumes picking up over the years. In many markets we need to maintain the same levels of inventory as before while the volumes have grown significantly.

10. TAXATION

The higher taxation issue – consequent to Tax department disallowing some R&D expenses and the retrospective liability is not understood by the larger Investment community. kindly throw more light?

Well it’s really a matter of interpretation. They have chosen to interpret the laws now in a different way, as simple as that. and they have the powers vested in them. Rather than litigate, we have chosen to comply and move on.

So is this behind us now? This is a closed chapter and no further liability is accruable?

Yes of course. This was a 6 year assessment. Some other big-pharma companies were served with similar claims and they too have complied.

Can you explain a bit on the difference in interpretations now and in earlier years?

TBC

So the whole industry has chosen to comply. There is no one who has a different take?

Correct. No one has gone for challenging the new rulings/interpretation.

What about when the Dahej SEZ facility starts operations? That should result in some tax concessions?

11. DPCO IMPACT

Two things. First our volumes form the domestic market are very low. This becomes significant for large players with revenue volumes of 3000 Cr or more at stake. For Ajanta domestic market stake is low at ~300 Cr or so. Secondly the niche specialty segments are much less on the control radar than the mass volume segments like anti-infectives or anti-biotics.

12. GROWTH/PROFITABILITY

Recent growth has been at 40% levels. Recent EBITDA levels have seen expansion to over 26%. Kindly throw some colour on sustainable levels for the company for next 2-3 years.

We maintain we will be happy to grow at 20% rates consistently. EBITDA levels are currently sustainable at 22-23% probably. In 2 years time when new Capex is operational that would perhaps lower to 20-21% levels. We would never operate below 20% EBITDA levels perhaps.

13. LONG TERM PROGRESS/NEXT MILESTONES

Well next 3 years – we will look to maintain our steady progress.

5 years down the line ?

TBC

14. CONSISTENT PROMOTER BUYING/PLEDGING

As explained in our last interaction as well, the promoters are enhancing stakes in the natural scheme of things. Pledging is only by way of financing additional share purchases.

But this seems to have accelerated?

As on Mar 31st pledged shares was at 11 lakhs. Today this is at 7 lakhs.

Disclosure(s)

Ayush Mittal: More than 5% of Portfolio in the Company; Holding for more than 6 months; Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 2 years; : ; ; : ; ;

Management Q&A

If Kaveri is to do a 20-25% increase over last year, you should be doing ~50 lakh packets in 2014E. Where will that growth come from?

Most of the growth will have to come from AP & Maharashtra. We introduced our hybrids early in AP, so we have some advantages there. In Maharshtra, the competition is more.

KAVERI PENETRATION STRATEGY

KAVERI ANDHRA PRADESH PENETRATION STRATEGY?

TELENGANA(10 districts)

COASTAL(9 districts)

RAYALSEEMA(4 districts)

Dominance

2013

2014E

2013

2014E

2013

2014E

Nuziveedu

1

1

all equal

all

Mahyco

4

2

all equal

all

Kaveri

2

3

1

1

all equal

all

Azith

3

4

Ankur

Total (90 lakh packets)

60 lakh packets

22-23 lakh packets

5-7 lakh packets

Is it right to say Jadoo Hybrid has seen very good acceptance in Coastal areas, post Neelam cyclone; earlier the response was mixed? Apart from good yield, makes for easy plucking (just a finger tap is enough), a leading non-Kaveri distributor told us.

Jadoo has shown good acceptance almost everywhere – not just Coastal AP. Adilabad district is the only one where Jadoo has not done well. Even in Telengana Jadoo has done well esp. in Khammam & Mehboob Nagar districts. Also in Medak district.

Jadoo plant is tall with strong stem. Ball-to-Ball distance is less. Jadoo has shown some tolerance to Sucking Pest. The best part about Jadoo is its higher yield. The plant rejuvinates and gives a second yield which is 30% of the first.

Only 30-35% sales Advance basis; 60-65% Sales PUSH Sales?

The advance we receive is 30-35% of Sales. Credit Sales is not more than 5-10%

Impact on Kaveri Seeds?

We didn’t have any unsold inventory last year. Marketing Expenses will be higher, as everyone will resort to aggressive marketing.

Lower performing brands – for them it is a matter of do or die – survival??

Yes. Those who carry over inventory for the second year running may find it tough to survive.

Risk of Advance payment Terms changing to Cash basis??

Not for the better-performing hybrids.

What if this was to continue for 1 more year?

You see the RISK is totally based on the demand for your hybrid. If there is demand for your hybrid, you can sell it after 2 years too. But if there is low demand, then you will have a tough time selling it ever!

4. 2014E – INVENTORY PICTURE /BIG 5

Mahyco and Ajith seem to have managed to scale up production levels – from ground vacated by smaller players?

2013

2014E

Nuziveedu

100

Mahyco

20

Kaveri

40

Azith

15

Mahyco had done 25-30 lakh packets last year. Azith had also done 25-35 lakh packets. Ankur had done almost 30-35 lakh packets. Monsanto Emergent had done 15-20 lakhs. Vibha had done 15-20 lakhs. Tulasi has done 15-17 lakhs. And there are also Mahyco types that do well! In the North, DCM Shriram did very well ~20-25 lakh packets.

Most bigger players are reported to have scaled up production 2x-3x? Most have to lose out??

Its going to be an extremely competitive season. Those with better performing hybrids will do better.

One view is Mahyco most well-placed to capture back lost ground? market share? What farmers paid Rs 2000 last year, they will get at Rs 930 this year.

The other view is that those who paid Rs 2000 last year did not benefit. Mahyco should be able to do 20% more than last year.

Why will Kaveri even maintain existing Sales? On such a high base?

We should do atleast 20% more. Yes we had more than doubled our Sales last year. But that also means our base of satisfied farmers is much bigger. We have atleast 3x more satisfied farmers. Our hybrid Jadoo has done extremely well. 70% of our Sales is driven by Jadoo. No competitor has one single hybrid accounting for such a high proportion of Sales. Nuziveedu’s Banni & Mallika together reportedly contribute around 50-55 lakh packets.

What Sales Promotion activities have you planned?

As we have indicated before we expect intense competition, this year. Kaveri will be using local-language advertisements in regional media for the first-time. We are ready with the Advertisements.

What about dealer/distributor incentives like Foreign travels?

These have been going on. We want a situation where the farmer should ASK for our product. So we will focus more on PULL for our product(s) than PUSH sales, though that too has its role.

Margin pressures?

We think we will be able to maintain margins. Normally we would have seen an increase in margins on higher volumes. But because of the intense competitive activity there will be higher spend on sales promotion.

5. CONTRACT FARMING – CHALLENGES/ MAINTAINABILITY/ SCALABILITY

The overall land available for contract farming isn’t expanding; it can only be reducing for several reasons. Producing at even 20% more each year, seems a very big challenge to keep managing?

Its not entirely true that the land available is reducing. There are new areas that have taken up contract farming. For Cotton, the entire production area about 130,000 acres is in AP (70%) and Karnataka, Gujarat & Maharashtra (30%).

We have 75-80% of our production in Gadwal (Mahboobnagar district) & Nandhyal (Kurnool district) in AP which are higher yield regions. We also procure from Eluru region from West Godavari district.

Challenge seems to be to hold on to contracts/relationships. Once you scale down, scaling up may be much more difficult/costly.

Farmer’s incentive is Yield. Having a higher yield reduces cost of production. The other way is to commit more money to the farmer.

6. PRODUCTION -OVERESTIMATION RISKS

There seems to big risks of Inventory Carry-over?

There might be some who are carrying inventory over from last year. For players like us who had near-zero inventory last year, it is not a big risk.

But the bigger longer-term risk seems, if one were forced to cancel/scale down contract farming relationship size

Yes, there are challenges here, but it’s not impossible (to scale back). You must remember Kaveri has scaled up in the last 2-3 years from nowhere. Good higher-yield hybrids play their part too, as production costs are less for the farmer.

Is it possible someone is off the mark by 40-50%? That will have a cascading pattern?

Yes it is possible. There are some players who are carrying 2-3 years inventory.

7. COTTON SEED PRODUCTION PATTERN

Can you please explain how do you go about sowing/procuring the required production seed quantity?

Sowing time is generally between February to October – at different times in different regions – to spread our risks on the weather/climatic front. Usually it takes 120-140 days for seed to be available – harvesting, ginning for seed, and quality control.

So July-Aug, the first seeds become available, and we continue to get seeds till May.

Is it correct to say 2nd batch from Jan-Mar is usually much larger?

One can forward project anything! The key thing to see is how much we can sell. And that picture looks like 20-25% higher over last year.

What if Kaveri underachives targets?

We are reasonably confident of achieving 20-25% higher sales

9. FUTURE – GROWTH

How does the future of hybrid seeds look?

We see growth continuing for at least a decade.

Any impact of new technologies? Others are experimenting with Closer Density plantations and mechanical plucking/cutting?

Yes. These will probably start getting introduced 2-3 years later. We are also working with closer density planting. Mechanical plucking/cutting work with mostly varietals (non-hybrids), short-duration crops with 1 time harvesting, etc.

10. FUTURE – HYBRID RICE

2.5 mn hectares – mostly North India? Why not in South India?

Currently hybrid rice is available in thicker rice varieties. In South India, slender rice – Sona Masuri varieties are more preferred.

How far from solving Quality issue? We have heard hybrid rice is mostly sticky rice?

Stickiness problem is already solved. Much of the technical challenges are being solved. Yield is much higher – minimum is 20%. Work is going on in Draught resistance – where once a week watering will be enough. Resistance to pests is being brought in. Unlike Maize (7 mn hectares) Rice is grown in 40 Mn hectares in India, so the potential is big.

So are we going to see widely acceptable commercially available products in 2-3 years?

More like 5-7 years.

11. FUTURE – MAIZE GROWTH DRIVERS

Poultry Consumption/Paddy or Cotton Conversion/Easy cultivation/Mechanisation/2 crops in a year – many advantages. Do you see major shifts from Cotton to Maize

Maize is cultivated in 7 million hectares. Poultry and starch industries are main drivers for maize cultivation. Some of the other drivers you cited augur well for the future of Maize cultivation in India. So a stable picture for Maize seeds demand is envisaged. It is a high margin business, as prices are market determined, with no price caps. Monsanto dominates the Corn business. We are among the Top 3. But Maize is also a very sensitive crop, if it doesn’t rain, the crop suffers.

125 Cr FY13, FY14E?

It should see normal 10-15% growth

12. TAXATION

Unlike your company, Some Seed companies are still paying Taxes at full rates? Like DCM Shiram on Seed division income? What are the risks of taxes being levied retrospectively?

Yes, and there are many others who are of the view that taxes are not applicable for this sector. Recent court orders have vindicated this stand. Tax Laws are the same. It’s interpretation cannot/shouldn’t be different for different Assessment Officers. Monsanto is not paying these taxes. Our view is simply this – We have paid full tax in earlier years. We then claimed Refund as per the existing law, and we got back the full amount from the government. That kind of settled it for us.

13. REGULATIONS

The Maharashtra Government order cancelling the company’s (Mahyco) licence? Last time round you were pretty confident of the order getting reversed. What’s the latest status?

If we look at this objectively, with this government order, who’s suffering? It’s the farmer. The farmer needs to have access to good quality seeds. If it comes to that, the farmer can always buy the seeds at the border.

Disclosure(s)

Tirumal Rao: More than 5% of Portfolio in the Company; Holding for more than 1 year; Davuluri Omprakash: No Holdings in the Company; ; Vinod MS: More than 5% of Portfolio in the Company; Holding for more than 1 year; Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 2 years;

Management Q&A

1. FOREX DERIVATIVE CONTRACTS – OUTSTANDING?

Please explain the current situation on Forex derivative contracts.

This is over. We have paid back all outstanding. 15th October was the last payment tranche. This was a significant drag on the performance of the company with almost 3Cr/month of losses. Now this will add straight to the bottomline.

2. MAIN PRODUCT SEGMENTS

Kindly tell us more on your main product segments.

IV Cannula account for 50% by Quantity. Rest 50% is from other products. We are manufacturing as many as 93 different products.

How much do you expect Safety IV Cannula to contribute eventually?

Eventually this segment should contribute 10-15% of Sales

3. US CONTRACTS

What is the current status of the US contracts bagged by the company?

There are actually two contracts. The first one is for Blood Bags and that is going on as scheduled. The 2nd one is for Safety IV Cannula. This needed some design change and the project was pushed back by 6-8 months.

This is back on schedule now. Supplies should commence from Q1FY14.

How much this likely to start contributing?

About 20-30 Crs

4. MARGINS/PROFITABILITY IMPROVEMENT

If we were to remove the effects of the Forex derivatives losses, there seems to be big jumps in operating margins? Is it the right picture?

In previous years the company implemented measures for improving growth and profitability through backward integration and cost cutting mechanisms.

This year the company focused on plugging leakages and cutting wastage. There was a big drive in FY12 in improving profitability, driven mainly by the pressure from the losses on derivative contracts which was significant. But because of the drive there are now long term benefits.

We identified Raw Materials (RM) as a big area for cost-savings. We improved our sourcing significantly (from China and the sourcing knowhow from there), plugged leakages.

In our plant we used to have 6-7 hour powercut at times. The moulding material in the moulding machines would get stuck. There was wastage as well as delays due to this. So we invested in heavy-duty UPS (25-30 lakh) systems for uninterrupted operations. Earlier we had 32 cavity moulds. We have replaced them with 64 cavity moulds. We made big investments, but these will come with long term benefits.

Are the higher margins sustainable?

Like I said before, there are long term benefits. Should be sustainable because of operating efficiencies coupled with economics of scale. We are investing significantly on automation front.

Any new expansion will have significant automation. For example the next expansion at this plant (Faridabad) is an expansion cum automation plant. From 40 operators/line this will be down to 20/line. We will also be setting up a fully automated IV plant. from 53/line this will come down to 3/line. This will not only add capacities, reduce variable costs, but also increase consistency & quality.

5. LITIGATION WITH B. BRAUN – SAFETY IV CANNULA

What’s the latest status? Have there been significant costs?

Cases have been filed in many countries. Its moving through the legal/Appeals process. Everywhere we have won. We have won in Germany Apex Court. We have won in Italy and Malaysia. There have been significant costs yes, but at some places we have got back with costs.

As you are aware the Safety IV Cannula cost us some 5-6 Cr in development costs. RM addition is just 20 paise per unit. But Safety Cannula we are able to sell at Rs 15-17 per unit versus Rs 5.5 per unit of normal IV Cannula. The needles used to be imported earlier, now we make them here at 1/4th the cost. RM is still imported.

6. DOMESTIC BUSINESS THRUST

From recent announcements/expansion plans we are seeing some focus on the domestic market? Kindly elaborate.

Yes, we are expanding capacities to cater to the surging demand in domestic market as well. You see the ROMSONS group altogether (6 group companies) is doing a Rs 300 Cr Turnover in India. In contrast we hardly do 50-60 from this market, so there is a lot of scope.

So what are the new initiatives?

We used to mainly participate in Tendered business. NACO (National Aids Control Organisation) and other Tenders. There are few players in blood bags, not huge competition.

In the last 6-8 months, we have now appointed some Super Distributors, some 10 in the country. These are working well.

7. LOCAL COMPETITITION

Kindly give us a sense of the competition in the domestic industry?

Hindustan Syringes – This is the pioneer and 50 year old company in the medical disposables business. Primarily (90%) into Syringes. So some 10% of our products are common

Eastern Medikit – This company 5 yrs back was doing very well at Rs 250 Cr turnover. we were only 100 Cr then. There were some labour problems, and there were questions/ qualifications on balance sheet. This company has closed down recently.

ROMSONS – This is also a 50 year plus company, actually 5-6 group companies in the disposable medical & surgical devices segment in India. They currently have combined gropup turnover of ~300 Cr.

8. JAIPUR FACTORY

Kindly explain the move to Jaipur?

Well as you might be aware there is no space for expansion at Haridwar or Faridabad plants. We have applied for another plot in HSIDC, Faridabad. The Jaipur facility allows us some diversification (plant+labour and other fronts). Senior Management is already present in Jaipur managing 2 group companies so adequate management bandwidth is already available. Besides Rajasthan has a few companies in medical disposables space like Ahlcon Parenterals (catering to Blood Bags) recently acquired by B Braun.

What will the Capital expenditure required?

Roughly 20-22 Cr. 6-7 Cr for land and 15 Cr plant & machinery.

There was an announcement of Rs 100 Cr Capex spend?

That is for the overall Capex envisaged spread over next 1.5 to 2 years. The other locations will also see expansions/additional spends. As mentioned before we have another plot applied for in HSIDC, Faridabad.

9. PATENTS

There are so many manufacturers of products like IV Cannula and other such disposable products, and each have claims to 100s of patents? What’s the real use of these patents?

We use patents worldwide. We apply for patents only if we are having sales in that country. These serve the purpose of only a restrictive mechanism – so direct identical copy of any product cannot be made & sold; some redesign will have to be done before selling in the same country a similar product.

10. ENTRY BARRIERS

So what really are the entry barriers in your business?

a) There is heavy upfront capital investment. 95% of machines are imported
b) Huge focus on innovation – You have to keep innovating to survive
c) Regulations are becoming stricter

So what is your unique selling proposition (USP)?

In one word “Innovation”. We have been continuously investing in R&D. R&D spend in FY2012 was ~3Cr, up from ~70 lakh levels a few years back.

11. FOREX AND HEDGING POLICY

Kindly explain the Forex derivative contract, due to which you faced such heavy losses. Now that is behind us, what is the current hedging policy?

You see last 2 quarters, US$ – Rupee has been at ~52-57 levels. As per our derivative contracts, delivery was at 40-to the US$. Hence the big losses.

Current hedging is on Net Exposure. 60% is open and 40% hedged.

12. EXPORT BUSINESS

Kindly give us a sense on the Export Business. How much of it is based on long term contracts, and how do you ensure payments/receivables?

Yes, long term contracts work best for us on the payments front. In countries with geopolitical RISKS, we work only on advance payment/cash basis. Rest of the countries, its regular LC basis.

What is the effect of Europe region slowdown?

You will be happy to know we are in a different business. There is no effect in a slowdown/recession scenario. Medical sector does better sometimes.

13. US MARKET

When are we going to see Poly Medicure’s entry in the largest Medical market, the US?

We have some ~95 products. As of now the Safety feature is incorporated only in 3-4 products. And as you are aware, you can’t sell in the US Market w/o safety features. We are looking to incorporate safety feature in a few more products, then introduce as a basket – may be after a year or so.

You had acquired an US subsidiary/factory? what are the plans?

No plans of operations. May be use that company for Marketing set-up.

14. EGYPT SUBSIDIARY

What’s the status on this subsidiary? How is it doing?

This JV is doing well. We have an equipment supply arrangement with the company. Currently we do ~20 Cr worth of supply annually with assured margins.

15. MEDIUM TERM OUTLOOK

Kindly give us a sense where the company is headed in the medium term?

We should do well and keep growing at 20-25%. Margins will improve. Cash Flows will improve significantly. In 2-3 years we should be in a happy cash-surplus situation.

Disclosure(s)

Ayush Mittal: More than 5% of Portfolio in the Company; Holding for more than 1 year; Donald Francis: No Holdings in the Company; ; : ; ; : ; ;